-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, J7LKgNwfv+gHd3hfUt/8+/SMCZns0caHNytiOCXV7eQzZdA3LzQB/hNmycQLLhlT L2v8bXDP1wB7zJRoPvAtOQ== 0000813775-03-000003.txt : 20030502 0000813775-03-000003.hdr.sgml : 20030502 20030502101345 ACCESSION NUMBER: 0000813775-03-000003 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 10 CONFORMED PERIOD OF REPORT: 20030201 FILED AS OF DATE: 20030502 FILER: COMPANY DATA: COMPANY CONFORMED NAME: FACTORY 2 U STORES INC CENTRAL INDEX KEY: 0000813775 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-FAMILY CLOTHING STORES [5651] IRS NUMBER: 510299573 STATE OF INCORPORATION: DE FISCAL YEAR END: 0131 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-10089 FILM NUMBER: 03678287 BUSINESS ADDRESS: STREET 1: 4000 RUFFIN ROAD STREET 2: 6TH FLR CITY: SAN DIEGO STATE: CA ZIP: 92123-1866 MAIL ADDRESS: STREET 1: 4000 RUFFIN ROAD STREET 2: 6TH FLOOR CITY: SAN DIEG STATE: CA ZIP: 92123-1866 FORMER COMPANY: FORMER CONFORMED NAME: DRS INDUSTRIES INC DATE OF NAME CHANGE: 19920703 FORMER COMPANY: FORMER CONFORMED NAME: LONGWOOD GROUP LTD DATE OF NAME CHANGE: 19920527 FORMER COMPANY: FORMER CONFORMED NAME: FAMILY BARGAIN CORP DATE OF NAME CHANGE: 19940202 10-K 1 form10k.txt FORM 10K FOR FISCAL YEAR ENDED 020103 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For fiscal year ended February 1, 2003 Commission File number 0-16309 FACTORY 2-U STORES, INC. ------------------------ (Exact Name of Registrant as Specified in its Charter) Delaware 51-0299573 -------- ---------- (State or Other Jurisdiction of (I.R.S. Employer Identification Number) Incorporation or Organization) 4000 Ruffin Road San Diego, California 92123 --------------------- ----- (Address of Principal Offices) (Zip Code) Registrant's Telephone Number, Including Area Code: (858) 627-1800 -------------- Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- Common Stock, $0.01 par value None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value (Title of Class) Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K [X] Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). YES [X] NO [ ] At April 25, 2003, the aggregate market value of the voting stock of the Registrant held by non-affiliates was approximately $55,427,082. At April 25, 2003, the Registrant had outstanding 15,992,953 shares of Common Stock, $0.01 par value per share. PART I Item 1. Business 3 Item 2. Properties 11 Item 3. Legal Proceedings 13 Item 4. Submission of Matters to a Vote of Security Holders 13 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters 14 Item 6. Selected Financial Data 16 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 18 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 28 Item 8. Financial Statements and Supplementary Data 29 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 29 PART III Item 10. Directors and Executive Officers of the Registrant 30 Item 11. Executive Compensation 32 Item 12. Security Ownership of Certain Beneficial Owners and Management 40 Item 13. Certain Relationships and Related Transactions 42 Item 14. Controls and Procedures 43 PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 44 2 Cautionary Statement for Purposes of "Safe Harbor Provisions" of the Private Securities Litigation Reform Act of 1995 In December 1995, Congress enacted the Private Securities Litigation Reform Act of 1995 (the "Act"). The Act contains amendments to the Securities Act of 1933 and the Securities Exchange Act of 1934 which provide protection from liability in private lawsuits for "forward-looking" statements made by specified persons. We desire to take advantage of the "safe harbor" provisions of the Act. Certain statements in this Annual Report on Form 10-K, or in documents incorporated by reference into this Annual Report on Form 10-K, are forward-looking statements, which are within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are not based on historical facts, but rather reflect our current expectation concerning future results and events. These forward-looking statements generally may be identified by the use of phrases such as "believe", "expect", `estimate", "anticipate", "intend", "plan", "foresee", "likely", "will" or other similar words or phrases. Similarly, statements that describe our objectives, plans or goals are or may be forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements to be different from any future results, performance or achievements expressed or implied by these statements. The following factors, among others, could affect our future results, performance or achievements, causing these results to differ materially from those expressed in any of our forward-looking statements: general economic and business conditions (both nationally and in regions where we operate); trends in our business and consumer preferences, especially as may be impacted by economic weakness on consumer spending; the effect of government regulations and legislation; litigation and other claims that may be asserted against us; the effects of intense competition; changes in our business strategy or development plans, including anticipated growth strategies and capital expenditures; the challenges and costs associated with maintaining and improving technology; the costs and difficulties of attracting and retaining qualified personnel; the effects of increasing labor, utility, fuel and other operating costs; our ability to obtain adequate quantities of suitable merchandise at favorable prices and on favorable terms and conditions; the effectiveness of our operating initiatives and advertising and promotional strategies and other factors described in this Annual Report on Form 10-K and in our other filings with the Securities and Exchange Commission. We do not undertake to publicly update or revise any of our forward-looking statements, whether as a result of new information, future events and developments or otherwise, except to the extent that we may be obligated to do so by applicable law. PART I Item 1. Business GENERAL We operate a chain of off-price retail apparel and housewares stores in Arizona, Arkansas, California, Idaho, Nevada, New Mexico, Oklahoma, Oregon, Texas and Washington. We sell branded casual apparel for the family, as well as selected domestic and household merchandise at prices that generally are significantly lower than other discount stores. Our stores average approximately 15,000 square feet and are located mostly in shopping centers. Our products include a broad range of family apparel, domestic goods and houseware products. Our typical customers are families with more than the average number of children and average household income of approximately $35,000, which generally are profiled as discount store shoppers. Our merchandising strategy is to offer first quality recognizable national and discount store brands at a substantial discount, generally 20% to 50% below prices offered by other discount chains. Our stores are well lit and present the merchandise primarily on hanging fixtures. We also use strategically placed in-store signage to emphasize savings and create increased customer awareness. 3 We define our fiscal year by the calendar year in which most of our business activity occurs (the fiscal year ended February 1, 2003 is referred to as fiscal 2002). OPERATIONS Recent Developments As in fiscal 2001, we experienced a continuation of declining sales volume in fiscal 2002 with a decrease of 7.7% in comparable store sales for the year. The decline in comparable store sales was the result of lower transaction counts and lower purchase size. We believe there were a number of factors that contributed to the lower sales in fiscal 2002: (1) general economic malaise on the part of the consumer, partly exacerbated by the September 11 terrorists attacks and the threat of war in Iraq, (2) extreme price competition within the retail industry, which made it more difficult to maintain our price advantage, (3) higher fuel and utility costs, particularly in the state of California where more than half of our stores are located, (4) the pronounced effects of the September 11 terrorists attacks on our 17 stores located near the Mexican border, and (5) the deployment of United States armed forces overseas and the related negative impacts on our 42 stores located near military bases. In response to declining sales and operating losses over the last two fiscal years, we have taken steps designed to improve our future operating performance. To that end, on February 6, 2002, we announced a restructuring plan (fiscal 2001 restructuring) for the purpose of improving future operating results, which principally consisted of closing 28 unprofitable stores, realignment of our field organization and workforce reductions. We recorded a $21.2 million pre-tax charge in fiscal 2001 related to this restructuring effort. Beginning in November 2002, we also made a number of changes to our senior management team. In November 2002, we announced the appointment of William R. Fields to the position of Chairman and Chief Executive Officer, succeeding Michael Searles, our former Chairman and Chief Executive Officer. During fiscal 2002, we also appointed Edward Wong to the new position of Executive Vice President, Supply Chain and Information Technology, Melvin Redman to the position of Executive Vice President, Store Operations and Distribution and Larry Kelley to the position of Executive Vice President, Merchandising and Marketing. In a continuing effort to improve operating results, on December 6, 2002, we announced additional restructuring initiatives, which included the closure of another 23 under-performing stores, consolidation of our distribution center network, and reorganization of our corporate overhead structure (fiscal 2002 restructuring). In connection with this fiscal 2002 restructuring, we recorded a $14.4 million pre-tax charge. In addition, we announced efforts to liquidate our slow-moving and aged inventory chain-wide. We incurred a pre-tax charge of $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance. As a result of our financial results over the past two fiscal years, bankruptcy filings by a number of well-known retail chains during calendar year 2002 and the general weak economic environment, shortly after the Christmas selling season we experienced a tightening of credit extended to us by our vendors and the credit community for merchandise purchases. The initial impact of this credit tightening was a disruption of product flow to our stores in January, February and to a lesser extent March of 2003. This credit environment required us, in many cases, to meet accelerated payment terms in order to re-establish a consistent flow of product and assure a level of inventory for Spring 2003 business. The acceleration of payment terms, in turn, adversely affected our liquidity and, to some extent, further weakened our existing credit standing. In an effort to improve our liquidity position, obtain more reasonable credit terms and provide for a consistent flow of merchandise to our stores, we initiated a series of financing transactions, in addition to taking steps to accelerate the recognition of tax loss carry-back benefits. On March 6, 2003, we completed the private offering of approximately 2.5 million shares of our common stock for aggregate proceeds of approximately $5.7 million, net of placement fees. In addition, during March 2003, we received an $8.2 million federal tax refund as a result of utilizing tax loss carry-back benefits. On April 10, 2003, we completed a $7.5 million debt financing transaction consisting of a $6.5 million junior term note secured primarily by inventory and accounts receivable and a $1.0 million term note secured primarily by equipment and other assets. We also anticipate completing a sale/leaseback transaction covering 4 distribution equipment to be located in our new Otay Mesa distribution center with a value of between $3.0 million and $4.0 million in the second quarter of fiscal 2003. In April 2003, we have experienced an improved flow of merchandise product to our stores, a loosening of credit terms from the credit community and improved liquidity as a result of our capital raising efforts. To a large extent, our ability to obtain merchandise in the future on credit terms consistent with those that we have received historically will depend upon our ability to improve future operating results as measured by comparable store sales growth and operating margins. Operating Strategy At Factory 2-U, our goal is to become the nation's premier "Extreme Value Retailer" - providing the lowest price in the marketplace by using our aggressive, unique buying techniques. More specifically, we seek to be the leading off-price casual apparel, domestic goods and houseware retailer to families with more than the average number of children and whose household income is approximately $35,000 in the markets we serve. The major element of our operating strategy is to provide value to customers on national and discount brand apparel and houseware merchandise. We emphasize providing value to our customers by selling merchandise offered by national discount chains at savings of generally 20 to 50% below their prices. We buy excess in-season inventory of recognized brands at bargain prices and pass along the savings to our customers. We believe we are positioned to help families dress, decorate their homes and entertain their children at a great value. Buying and Distribution We purchase merchandise from domestic manufacturers, jobbers, importers and other vendors. Historically, our payment terms have typically been net 30 days. While we continually add new vendors, we have maintained stable and good business relationships with certain established vendors. However, we do not maintain any long-term or exclusive purchase commitments or agreements with any vendors. We believe that there is a substantial number of additional sources of supply of first quality, national and discount brand merchandise that will meet our inventory needs. Unlike traditional department stores and discount retailers (that primarily purchase merchandise in advance of the selling season, for example, back-to- school is purchased by March), we purchase approximately 80% of our merchandise in-season (i.e., during the selling season). These in-season purchases generally represent closeouts of vendors' excess inventories remaining after the traditional wholesale selling season and are often created by other retailers' order cancellations. We believe that in-season buying practices are well suited to our customers, who tend to make purchases on an as-needed basis during the season. For years, our customers have substantiated this pattern, which has helped shape the way Factory 2-U does business. Our in-season buying practice is facilitated by our ability to quickly process orders and ship merchandise through our distribution centers to our stores. At our administrative headquarters, we receive daily store sales and inventory information from point-of-sale equipment located at each of our stores. This data is reported by stock keeping unit (SKU), permitting us to tailor purchasing and distribution decisions on an as-needed basis. Our chain-wide computer network, which is currently being upgraded with a view to enhanced allocation and markdown capabilities, also facilitates communications between store management with timely pricing and distribution information. Generally, manufacturers ship goods directly to our distribution centers or freight consolidators who then ship directly to our distribution centers. We then deliver merchandise from our distribution centers to our stores within just two or three days of receipt utilizing the services of independent trucking companies. We do not typically store merchandise at our distribution centers from season to season. We believe we are a desirable customer for vendors seeking to liquidate inventory because we can take immediate delivery of large 5 quantities of in-season goods. We rarely request markdown concessions, advertising allowances or special shipping requirements, but insist on the lowest price possible. Merchandising and Marketing Our merchandise selection, pricing strategies and store formats are designed to reinforce the concept of value and maximize the customer enjoyment of shopping at our stores. Our stores offer customers a diverse selection of first quality, in-season merchandise at prices that generally are lower than those of competing discount stores in their local markets. Our stores generally carry an assortment of brand name labels, including nationally recognized brands. We deliver new merchandise to our stores at least weekly to encourage frequent shopping trips by our customers and to maximize our inventory turn. As a result of our purchasing practices and the nature of off-price retail industry, store inventory may not always include a full range of colors, sizes and styles in a particular item. We believe that price, quality and product mix are more important to our customers that the availability of a specific item at a given time. It is important that we emphasize inventory turns in our merchandising and marketing strategy. Our merchandise presentation, pricing below discounters, weekly store deliveries, staggered vendor shipments, promotional advertising, store-tailored distribution and prompt price reductions on slow-moving items are all designed to increase inventory turn. We believe that the pace of our inventory turn leads to increased profits, lower markdowns, and efficient use of capital and customer urgency to make purchase decisions. Our stores are characterized by easily accessible merchandise displayed on hanging fixtures and open shelves in well-lit areas. Our prices are clearly marked with the comparative retail-selling price often noted on the price tag. Our major advertising vehicle is the use of a full-color "tab" showing actual photos of our merchandise and also telling our story. Our print media is delivered to consumers through both direct mail and newspaper inserts. Some of our other advertising programs include radio commercials and billboards, as well as various local promotional activities from time to time. As we move forward, we will continue to evolve our "Extreme Value Retailing" position. It is an important, ownable marketing position that we feel will address more and more customers each day; a growth strategy we have the utmost confidence in. Our Stores Our stores emphasize value to the customer and satisfaction to develop customer loyalty and generate repeat business. If a customer is not completely satisfied with any purchase, we will make a full refund or exchange. Most of our sales are for cash, although we accept checks, debit and credit cards. We do not issue credit cards, but do offer layaway and gift card programs. Our layaway program is important to our customers, many of whom do not possess credit cards, because it permits them to pay for purchases over time. In general, our store business hours are from 9:00 am to 9:00 pm, seven days a week. As of April 25, 2003, we operated 243 stores located in Arizona, Arkansas, California, Idaho, Nevada, New Mexico, Oklahoma, Oregon, Texas and Washington, under various operating leases with third parties. Our stores are located in rural and lower to moderate income suburban communities and in densely populated metropolitan areas. Most of our stores are located in shopping centers. Our stores range in size from 6,000 square feet to 34,800 square feet, averaging approximately 15,000 square feet. We generally lease previously occupied store sites on terms that we believe are more favorable than those available for newly constructed facilities. We select store sites based on demographic analysis of the market area, sales potential, local competition, occupancy costs, operational fit and proximity to existing store locations. After we sign a new store lease, our new store opening team prepares the store by installing fixtures, signs, dressing rooms, checkout counters, cash register systems and other items. Once we take possession of a store site, it takes approximately eight weeks to open a new store. 6 Our average store opening costs for equipment, fixtures, leasehold improvements and pre-opening expenses approximate $295,000. Our average initial inventory for a new store currently approximates $160,000, net of trade credit. Generally, during the two to three month grand opening period, our new stores achieve sales that are 150% to 200% higher than the expected annualized net sales. Our stores typically employ one store manager, two to three assistant store managers and/or store supervisors, and 15 to 20 sales associates, most of whom are part-time employees. We train new store managers, assistant store managers and store supervisors in all aspects of store operations through our management-training program. Our other store personnel are trained on site. We often promote experienced assistant store managers to fill open store manager positions. Our store managers participate in a bonus plan in which they are awarded bonuses upon achieving established operating objectives. We continually review store performance and from time to time close stores that do not meet our minimal financial performance criteria. The costs associated with closing stores consist primarily of inventory liquidation costs, provisions to write down assets to net realizable value, teardown costs and the estimated cost to terminate the lease. Prior to December 31, 2002, such costs were charged to operations during the fiscal year in which the decision was made to close a store. For all closing decisions initiated after December 31, 2002, the closing costs will be recognized when they are incurred. We maintain customary workers compensation, commercial liability, fire, theft, business interruption and other insurance policies for all store, distribution and corporate office locations. Employees As of April 25, 2003, we had 4,577 employees (2,484 of whom were part-time employees). Of that total, 4,239 were store employees and store field management, 247 were executives and administrative employees and 91 were warehouse employees. None of our employees are subject to collective bargaining agreements and we consider relations with our employees to be good. Trademarks Except for the trade names "Factory 2-U" and "Family Bargain Center", which are federally registered trademarks, we do not have any material trademarks. Government Regulation Our business operations are subject to federal, state and local laws, regulations and administrative practices. We believe we are in substantial compliance with all federal, state and local laws and regulations governing our business operations and we have obtained all material licenses and permits required to operate our business. We believe that the compliance burdens and risks relating to these laws and regulations do not have a material adverse effect on our business. 7 Risk Factors New Store Growth In fiscal 2002, 2001 and 2000, we opened 12, 39 and 70 stores, respectively. During fiscal 2002 and 2001, we closed 50 stores. As of April 25, 2003, we had opened one new store and currently expect to open one additional new store in fiscal 2003. We have significantly reduced our new store growth in fiscal 2003 as a result of our recent financial performance and liquidity position. New store growth is dependent upon many factors, including general economic conditions, our financial condition and liquidity, availability and cost of real estate, and our ability to identify suitable markets and sites for our new stores. In addition, we must be able to continue to hire, train, motivate and retain managers and store personnel. Many of these factors are beyond our control. As a result, we cannot assure that we will be able to achieve our future expansion goals. Any failure by us to obtain acceptance in markets in which we currently have limited or no presence, attract and retain management and other qualified personnel, appropriately upgrade our financial and management information systems and control or manage operating expenses could adversely affect our future operating results and our ability to execute our business strategy. We also cannot assure that any new store growth will improve our oprating margins. A variety of factors are critical to the success of our new stores and such factors include but are not limited to store sales, store location, store size, lease terms, initial advertising effectiveness and brand recognition. We cannot assure that our new stores will achieve the sales per selling square foot and store contributions required to meet our minimum operational performance criteria. If our new stores on average fail to achieve our minimum operational performance criteria, new store expansion could produce a decrease in our overall sales per selling square foot and store contributions. Increases in advertising and pre-opening expenses associated with the opening of new stores could also contribute to a decrease in our operating margins. Our Store Concentration in California Poses Localized Risks As of April 25, 2003, we operated 127 stores in California, representing over half of our total store base. Accordingly, our results of operations and financial condition largely depend upon trends in the California economy. Operating costs, such as minimum wage, health care, workers' compensation, utilities and fuel in California have been significantly higher than other regions in the country where we currently operate. If operating costs continue to increase in California, they could continue to pose a negative impact to our overall store contribution and operating margins. In addition, California historically has been vulnerable to certain natural disasters and other risks, such as earthquakes, fires, floods and civil disturbance. At times, these events have disrupted the local economy. These events could also pose physical risks to our properties. The costs associated with workers' compensation insurance in the state of California have increased significantly over the past two years. These cost increases are related to the average cost per claim and the related state benefits. In the state of California, the average workers' compensation claim is significantly higher than the other states where we currently operate. In January 2003, the state of California increased the maximum workers' compensation benefits by approximately 20 percent. With these continued workers' compensation cost increases and the uncertain economy, the continued rise in benefits could have a material impact on operating results in the future. In California, we employ, both in our stores and in our corporate headquarters, a substantial number of employees who earn wages near or at the minimum wage. Actions by both the federal and California state government have increased and may continue to increase the minimum wages that we must pay to such employees. We can make no assurances that these or other future wage increases will not have a negative impact on operating results in the future. 8 Utility costs for electricity and natural gas in California have risen significantly. These costs may continue to increase due to the actions of federal and state governments and agencies, as well as other factors beyond our control. We have attempted to mitigate such increases through energy conservation measures and other cost cutting steps. However, we can make no assurances that these measures and other steps taken will be adequate to control the impact of these utility cost increases in the future. In addition, increasing utility and fuel costs, together with high unemployment, may significantly reduce the disposable income of our target customers. There can be no assurance as to the impact these cost increases may have on sales to our core customer base in California or elsewhere. Disruptions in Receiving and Distribution Could Impact Our Business Well-organized and managed receiving and shipping schedules and the avoidance of interruptions are vital our success. From time to time, we may face unexpected demands on our distribution operations that could cause delays in delivery of merchandise from our distribution centers to our stores. A fire, earthquake or other disaster at our distribution centers that disrupts the flow of merchandise for any length of time could negatively impact our operating results and financial condition. We maintain commercial property and business interruption, earthquake and flood insurance. During April and May 2003, we will be closing our two existing distribution centers in San Diego and consolidating their operations into a single, new distribution center in San Diego. We may face unexpected or unforeseen demands, disruptions or costs that could adversely affect our distribution center operations and delay or interfere with our ability to deliver merchandise from our distribution facility to our stores in connection with this consolidation. Relationships with Our Vendors and the Availability of Close-Out and Excess In-Season Merchandise Affect Our Business Our success depends in large part on our ability to locate and purchase quality close-out and excess in-season merchandise at attractive prices. We cannot be certain that such merchandise will continue to be available in the future. Further, we may not be able to find and purchase merchandise in quantities necessary to accommodate our immediate needs or future growth. Although we believe our relationships with our vendors are good, we do not have long-term agreements with any vendor. As a result, we must continuously seek out buying opportunities from our existing suppliers and from new sources. We compete for these opportunities with other wholesalers and retailers, discount and deep-discount chains, mass merchandisers and various privately-held companies and individuals. Although we do not depend on any single vendor or group of vendors and believe we can successfully compete in seeking out new vendors, a disruption in the availability of merchandise at attractive prices could impair our business. In addition, our ability to purchase merchandise depends upon our receiving credit support from trade vendors or the credit community that extends financing terms to certain of our vendors. In light of general economic conditions and our recent financial performance, the credit community has either withdrawn or reduced their extension of credit for our purchase orders, which has disrupted our ability to purchase merchandise and impaired our business. Our recently completed equity and debt financing transactions have led to increased support from the credit community and our vendors. However, any further withdrawal or reduction of the extension of credit from the credit community and our vendors may negatively impact our ability to purchase merchandise at attractive prices, disrupt product flow and adversely affect our operating results. Our Business is Subject to Seasonality We have historically realized our highest levels of sales and income during the third and fourth quarters of our fiscal year (the quarters ending in October and January) as a result of the "Back to School" (July and August) and Christmas (November and December) seasons. Any adverse events during the third and fourth quarter could therefore affect our financial performance. Historically, we have realized a significant portion of our net sales and net income during these two 9 quarters. In anticipation of the "Back to School" and Holiday seasons, we may purchase substantial amounts of seasonal merchandise. If for any reason our net sales during these seasons were to fall below seasonal norms and/or our expectations, a seasonal merchandise inventory imbalance could result. If such an imbalance were to occur, markdowns might be required to clear excess inventory. Our operating results could be adversely affected by higher than expected markdowns. We Face Intense Competition We operate in a highly competitive marketplace. We compete with large discount retail chains, such as Wal-Mart, K-Mart, Target and Mervyn's, and other off-price chains, such as TJ Maxx, Ross Stores, Marshall's and Big Lots, some of which have substantially greater resources than ours. We also compete with independent and small chain retailers and flea markets (also known as "swap meets"), which serve the same low and low-middle income market. In the future, new companies may also enter the deep-discount retail industry. Although we believe that we are positioned to compete on the basis of the principal competitive factors in our markets, which are price, quality and site location, we cannot assure that we will be able to compete successfully against our current and future competitors. Over the past two years, the retail industry has experienced price deflation, primarily due to a weak economy and intense competition. We compete in the discount retail merchandise business, which is a highly competitive environment that subjects us to the price competition, the potential for lower net sales and decreased operating margins. We expect the competition will continue and increase in the future. In addressing this competitive environment, we have initiated new merchandise strategies, including new price point offerings, better execution of our core businesses and a revised print advertising tab; all designed to improve customer frequency and attract new customers. However, we can make no assurances that these strategies and other actions taken will be adequate to minimize our exposure to any negative impacts due to competition. Our Business is Vulnerable to Economic Factors Beyond Our Control Our ability to provide quality merchandise at everyday low prices profitably could be hindered by certain economic factors beyond our control, including but not limited to: o increases in inflation; o increases in operating costs; o increases in employee health care and workers' compensation costs; o increases in prevailing wage levels; and o decreases in consumer confidence levels. Terrorism and War May Affect Our Business Terrorist attacks, such as the attacks that occurred in New York and Washington D. C. on September 11, 2001, the response by the United States initiated on October 7, 2001, the war in Iraq that began on March 20, 2003 and other acts of violence or war may affect the market on which our common stock will trade, the markets in which we operate, and our operations and operating results. The near-term and long-term effects of war and any future terrorist attacks may have for our customers, the market for our common stock, the markets for our products and the economy of the United States of America are uncertain. The consequence of any terrorist attack or any armed conflicts that may result are unpredictable, and we are unable to foresee events that could have an adverse effect on our markets or our business. Our Business is Subject to Many Environmental Regulations Under various federal and local environmental laws and regulations, current or previous occupants of property may become liable for the costs of removing any hazardous substances found on the property. These laws and regulations often impose liability without regard to fault. We lease all of our stores. Although we have not been notified of, and are not aware of, any current environmental liability, claim or non-compliance, we could incur costs in the future related to our leased properties. 10 In the ordinary course of our business, we sometimes handle or dispose of commonplace household products that are classified as hazardous materials under various environmental laws and regulations. We have adopted policies regarding the handling and disposal of these products and we train our employees on how to handle and dispose of them. We cannot assure that our policies and training will successfully help us avoid potential violations of these environmental laws and regulations in the future. Effects of Anti-Takeover Provisions and Control by Our Existing Major Shareholders In addition to some governing provisions in our Certificate of Incorporation and Bylaws, we are also subject to certain Delaware laws and regulations which could delay, discourage and prevent others from initiating a potential merger, takeover or other change in control, even if such actions would benefit our shareholders and us. Moreover, we have a single shareholder that currently owns more than 20% of our voting stock. As a result, they may have certain ability to influence all matters requiring the vote of our shareholders, including the election of Board of Directors and most or our corporate actions. They may also control our policies and potentially prevent a change in control. This could adversely affect the voting and other rights of our other shareholders and could depress the market price of our common stock. The Market Price of Our Common Stock has had Substantial Fluctuation The market price of our common stock has fluctuated substantially since our recapitalization occurred in November 1998. Trading prices for our common stock could fluctuate significantly due to many factors, including: o the depth of the market for our common stock; o changes in expectations of our future financial performance, including financial estimates by securities analysts and investors; o variations in our operating results and financial condition; o conditions or trends in our industry; o additions or departures of key personnel; and o future issuances of our common stock. AVAILABLE INFORMATION We make available at our web site, www.factory2-u.com, our filings on Form 10-K, 10-Q, 8-K and amendments thereto, as soon as reasonably practical after we file such materials with the Securities and Exchange Commission. All such materials are free of charge. Any information that is included on or linked to our Internet site is not a part of this report or any registration statement that incorporates this report by reference. Item 2. Properties As of April 25, 2003, we operated 243 retail stores located in 10 states, under various operating leases with third parties. Our store locations include shopping centers, downtown business districts, malls and freestanding sites. Each store lease is separately negotiated. The lease term for our stores is between five to ten years with renewal options typically in five-year increments. Approximately 98% of our leases are "triple net leases" under which we are required to reimburse landlords for insurance, real estate taxes and common area maintenance costs; however, for many of those leases, we have negotiated reimbursement limitations on common area costs. As well as the monthly minimum base rent, some of our store leases require additional rent, which generally is based on an agreed percentage of sales in excess of a specified sales level. Our store rent expense for the fiscal year ended February 1, 2003 was approximately $38.1 million. 11 At February 1, 2003, we operated 244 stores under the name Factory 2-U. The number of stores we operated in each quarter during fiscal year 2002, 2001 and 2000 were as follows: 2002 2001 2000 -------- -------- -------- As of the beginning of the first quarter 279 243 187 Open 5 9 25 Close (28) (1) (9) -------- -------- -------- As of the end of the first quarter 256 251 203 Open 3 12 11 Close (2) - (3) -------- -------- -------- As of the end of the second quarter 257 263 211 Open 4 12 20 Close - (2) - -------- -------- -------- As of the end of the third quarter 261 273 231 Open - 6 14 Close (17) - (2) -------- -------- -------- As of the end of the fourth quarter 244 279 243
Subsequent to February 1, 2003, we opened one new store and closed two stores. As of April 25, 2003, our stores were located as follows: State Strip Center Downtown Power Center Freestanding Mall Total ----- ------------ -------- ------------ ------------ ---- ----- Arizona 24 2 4 1 1 32 Arkansas 2 - - - - 2 California 98 6 17 3 3 127 Idaho 1 - - - - 1 Nevada 7 - 1 - - 8 New Mexico 8 - 1 - - 9 Oklahoma 1 - - - - 1 Oregon 10 - 4 1 - 15 Texas 24 - 4 1 5 34 Washington 9 2 2 - 1 14 ------------ --------- ------------ ------------ ----- ----- Total 184 10 33 6 10 243 ------------ --------- ------------ ------------ ------ -----
Our headquarters are located in a 208,460 square-foot multi-use facility at 4000 Ruffin Road, San Diego, California. This facility consists of 58,460 square feet of office space and 150,000 square feet of distribution space. The lease on this facility expires in September 2005. The lease provides for annual base rent at an average of approximately $1.3 million for the remaining lease term. We also lease another 150,000 square foot distribution facility located at 7130 Miramar Road, San Diego, California. This lease expires in September 2005 and provides for annual base rent at an average of approximately $871,000 for the remaining lease term. Upon the opening of our new Otay Mesa distribution center in San Diego, California, currently anticipated in the second quarter of fiscal 2003, we will cease distribution activities at Ruffin Road and Miramar Road. The lease on this new distribution facility expires in July 2015 and provides for an annual base rent of approximately $2.6 million. We are currently seeking disposition of the leases for these two distribution facilities, although there can be no assurance that we will be able to dispose of these leases on favorable terms or at all. 12 In February 2001, we opened a 300,000 square-foot distribution center at 1875 Waters Ridge Drive, Lewisville, Texas. The lease for this facility expires in December 2007 and provides for annual base rent at an average of approximately $1.1 million for the remaining lease term. In conjunction with the expected opening of the new Otay Mesa distribution center in the second quarter of fiscal 2003, we plan to transfer the Texas distribution function to the new Otay Mesa distribution center upon the disposition of the lease for the Texas facility, although there can be no assurance that we will be able to do so. Item 3. Legal Proceedings On December 15, 2000, Pamela Jean O'Hara ("O'Hara"), a former employee in our Alameda, California store, filed a lawsuit against us entitled "Pamela Jean O'Hara, Plaintiff, vs. Factory 2-U Stores, Inc., et al., Defendants", Case No. 834123-5, in the Superior Court of the State of California for the County of Alameda (the "O'Hara Lawsuit"). On August 2, 2001, O'Hara and four other former employees in our Alameda store filed a Second Amended Complaint in the O'Hara Lawsuit. The Second Amended Complaint in the O'Hara Lawsuit alleges that we violated the California Labor Code and Industrial Wage Commission Orders, as well as the California Unfair Competition Act, by failing to pay overtime to the plaintiffs. Plaintiffs purport to bring this action on behalf of themselves and all other store managers, assistant store managers and other undescribed "similarly-situated employees" in our California stores from December 15, 1996 to present. The Second Amended Complaint sought compensatory damages, interest, penalties, attorneys' fees, and disgorged profits, all in unspecified amounts. The Second Amended Complaint also sought injunctive relief requiring payment of overtime to "non-exempt" employees. On September 4, 2001, we filed an answer in which we denied the material allegations of the Second Amended Complaint. Pursuant to an Order dated December 3, 2001, the Court in the O'Hara Lawsuit granted Plaintiff's motion for certification of two plaintiff classes: (1) all persons who have been employed as assistant store managers at one of our California stores at any time after December 15, 1996, and who worked hours which would have entitled them to overtime had they not been exempt employees; and (2) all persons who have been employed as store managers at one of our California stores at any time after December 15, 1995, and who worked hours which would have entitled them to overtime had they not been exempt employees. We made a settlement offer to each member of the two plaintiffs classes, pursuant to which we offered to pay $1,000 for each year of service (or a pro rata portion of each partial year) after December 15, 1996 and between February 1, 2002 in exchange for a release of all overtime claims. Approximately 263 members of the plaintiff classes accepted the settlement offer. In August 2002 we reached a tentative settlement of the O'Hara Lawsuit. On November 7, 2002, the Court entered an order granting final approval of the settlement agreement. Pursuant to the settlement agreement, we have agreed to pay the plaintiff class members (and their attorneys) a total of $2,000,000 in settlement of all their claims. The settlement became effective as of April 25, 2003. On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our current employees, filed a lawsuit against us entitled "Lynda Bray, Masis Manougian, etc., Plaintiffs, vs. Factory 2-U Stores, Inc., etc., Defendants", Case No. RCV071918 in the Superior Court of the State of San Bernardino (the "Bray Lawsuit"). The complaint in the Bray Lawsuit alleges that we violated the settlement agreement in the O'Hara Lawsuit, the California Labor Code, Industrial Wage Commission Orders and the California Unfair Competition Act by failing to pay wages and overtime for all hours worked, by failing to document all hours worked, by threatening to retaliate against employees who sought to participate in the settlement of the O'Hara Lawsuit and by failing to inform prospective employees of unpaid wage claims. Plaintiffs purport to bring this action on behalf of all persons who were employed in one of our California stores at any time after December 15, 1996. Plaintiffs seek compensatory and exemplary damages, interest, penalties, attorneys' fees and disgorged profits in an amount which plaintiffs estimated to be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring correction of the alleged unlawful practices. We believe that the material allegations of the complaint in the Bray Lawsuit are false and that each of the claims asserted in the Bray Lawsuit is meritless. We also believe that the settlement in the O'Hara Lawsuit bars some of the claims asserted in the Bray Lawsuit. We intend to vigorously defend against the Bray Lawsuit. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of our security holders during the fourth quarter of the fiscal year ended February 1, 2003. 13 PART II Item 5. Market for Registrant's Common Equity and Related Stockholder Matters Market Information Our Common Stock is traded on the NASDAQ National Market under the symbol "FTUS." The following table sets forth the range of high and low sales prices on the NASDAQ National Market of the Common Stock for the periods indicated, as reported by NASDAQ. Such quotations represent inter-dealer prices without retail markup, markdown or commission and may not necessarily represent actual transactions. High Low ---- --- Fiscal 2001 ----------- 13 weeks ended May 5, 2001 $42.62 $21.00 13 weeks ended August 4, 2001 $34.85 $18.00 13 weeks ended November 3, 2001 $23.55 $12.89 13 weeks ended February 2, 2002 $20.90 $14.17 Fiscal 2002 ----------- 13 weeks ended May 4, 2002 $18.31 $11.35 13 weeks ended August 3, 2002 $16.49 $10.61 13 weeks ended November 2, 2002 $10.91 $ 1.11 13 weeks ended February 1, 2003 $ 5.64 $ 1.45 Fiscal 2003 ending January 31, 2004 ----------------------------------- Through April 25, 2003 $ 5.17 $ 1.67
As of April 25, 2003, we had approximately 236 stockholders of record and approximately 2,082 beneficial stockholders. Dividend Policy We have never paid cash dividends on our Common Stock and do not anticipate paying cash dividends in the foreseeable future. The declaration and payment of any cash dividends on our Common Stock in the future will be determined by the Board of Directors in light of conditions then existing, including our earnings, financial condition, cash requirements and contractual, legal and regulatory restrictions relating to the payments of dividends and any other factors that our Board of Directors deems relevant. We are contractually prohibited from paying cash dividends on our Common Stock under the terms of our existing revolving credit facility and junior subordinated notes without the consent of the lender and note holders. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - - Revolving Credit Facility." 14 Equity Compensation Plan Information The following table sets forth information with respect to our common stock that may be issued upon the exercise of stock options under our Amended and Restated 1997 Stock Option Plan, together with information relating to our common stock that may be issued under plans not approved by stockholders. (a) (b) (c) Number of Securities Remaining Available Weighted for Future Issuance Number of Average Under Equity Securities to be Exerxise Compensation Plans Issued Upon Exercise Price of (Excluding Securities of Outstanding Outstanding Reflected in Plan Category Options Options Column (a)) - ------------------ -------------------- ----------- --------------------- Equity Compensation 1,273,404 $ 14.25 93,942 Plans Approved by Stockholders Equity Compensation Plans 450,000 $ 2.32 Not Applicable Not Approved by Stockholders* - ------------------------------------------------------------------------------- * Represents shares of common stock to be issued under outstanding options in connection with individual agreements described under "Compensation of Directors and Executive Officers - Employment Contracts with Named Executive Officers." All such shares will be issued under our Amended and Restated 1997 Stock Option Plan if approved by our stockholders, but have been excluded from the calculation of shares to be issued under the Plan for purposes of this table because we are contractually obligated to issue them outside of the Plan if an appropriate amendment to the Plan is not approved.
Unregistered Sales of Securities On March 6, 2003, we completed the private offering of 2,515,379 shares of our common stock to accredited investors for aggregate proceeds of $5,712,804 (net of placement agent fees of $217,415), together with a warrant to purchase an additional 75,000 shares of our common stock. The warrant, issued to the placement agent, is exercisable at a purchase price of $3.50 per share and expires on March 6, 2006. This offering was exempt from registration under Rule 506 of Regulation D of the Securities Act of 1933. 15 Item 6. Selected Financial Data The selected financial data set forth below, except for Operating Data, is derived from our audited financial information and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our Financial Statements, including the Notes, and Supplementary Data included in this Annual Report on Form 10-K. Fiscal Year Ended ----------------- February 1, February 2, February 3, January 29, January 30, 2003 (1) 2002 (2) 2001 (3) 2000 (4) 1999 (5) ----------- ----------- ----------- ----------- ---------- (in thousands, except per share and operating data) Statement of Operations Data - ---------------------------- Net sales $ 535,270 $ 580,460 $ 555,670 $ 421,391 $ 338,223 Operating income (loss) (45,050) (16,786) 31,868 22,753 10,464 Income (loss) from continuing operations before income taxes and extraordinary items (46,661) (17,746) 30,322 20,481 6,275 Net income (loss) (28,509) (10,896) 21,264 12,442 2,269 Dividends on Series A preferred stock - - - - 2,593 Dividends on Series B preferred stock - - - - 2,210 Inducement to convert preferred stock to common stock - - - - 2,804 Net income (loss) applicable to common stock (28,509) (10,896) 21,264 12,442 (5,338) Weighted average shares outstanding Basic 12,957 12,807 12,589 12,214 3,381 Diluted 12,957 12,807 13,066 12,864 3,381 Income (loss) before extraordinary items and discontinued operations applicable to common stock Basic (2.20) (0.85) 1.69 1.02 (0.77) Diluted (2.20) (0.85) 1.63 0.97 (0.77) Net income (loss) per common stock Basic (2.20) (0.85) 1.69 1.02 (1.58) Diluted (2.20) (0.85) 1.63 0.97 (1.58) Operating Data - -------------- Number of stores at fiscal year end 244 279 243 187 168 Total selling square footage at fiscal year end 3,021,000 3,459,000 2,979,000 2,169,000 1,804,000 Sales per average selling square foot $ 167 $ 178 $ 211 $ 209 $ 192 Comparable store sales increase (decrease) (7.7%) (8.7%) 4.4% 10.3% 10.9% Balance Sheet Data - ------------------ Working capital (deficit) $ (2,913) $ 14,633 $ 18,896 $ 1,241 $ (9,179) Total assets 126,504 155,709 142,265 108,466 90,167 Long-term debt and revolving credit facility, including current portion 15,746 10,376 11,218 11,067 13,773 Stockholders' equity 44,319 70,566 79,737 46,430 27,765 - ------------------------------------------------------------------------------------------------------ (1) Included the following pre-tax expenses: (a) $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance (cost of sales), (b) $2.8 million related to a long-term consulting project, which was terminated in November 2002, (c) $2.1 million related to a litigation settlement, (d) $14.4 million related to fiscal 2002 restructuring efforts, partially offset by a $5.0 million reserve reduction related to the fiscal 2001 restructuring efforts (as a result of favorable experience with lease termination costs), (e) $0.8 million related to the separation agreement of our former Chief Executive Officer, and (f) $2.2 million write-down of shareholders and trade notes receivable. 16 (2) Included pre-tax expenses of $21.2 million related to fiscal 2001 restructuring efforts, $0.5 million non-cash stock option charge, and $1.1 million related to the retirement and replacement of our former General Merchandising Manager. (3) Fiscal year included 53 weeks. Included pre-tax expenses of $4.8 million non-cash charge for performance-based stock options, partially offset by a $1.2 million condemnation award and $2.9 million after-tax reduction to our tax valuation allowance. (4) Included a pre-tax $2.1 million non-cash charge related to performance- based stock options. (5) Included pre-tax expenses of $1.0 million related to the merger of our wholly-owned subsidiary, $2.4 million in connection with the hiring of our President and Chief Executive Officer, and $2.8 million related to the exchange of subordinated reorganization notes.
17 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis should be read in conjunction with the information set forth under "Selected Financial Data" and "Financial Statements and Supplementary Data." General We operate a chain of off-price retail apparel and houseware stores in Arizona, Arkansas, California, Idaho, Nevada, New Mexico, Oklahoma, Oregon, Texas and Washington. We sell branded casual apparel for the family, as well as selected domestic and household merchandise at prices that generally are significantly lower than other discount stores. During fiscal 2001, we faced a difficult economic environment with a slowing economy, the impact of terrorist attacks on September 11, 2001 and a highly promotional environment within the retail industry. In addition, our customers and we experienced rising utility costs in California where half of our stores are located. We believe that our core customers were economically disadvantaged as a result of the difficult economic environment. Fiscal 2001 was a difficult year for retailers, particularly those with an apparel emphasis. We experienced declining comparable store sales, increased costs and declining operating margins in fiscal 2001. As part of our ongoing store evaluation process, in the fourth quarter of fiscal 2001, we reviewed our real estate portfolio and store operating performance and decided to close 28 under-performing stores (i.e., stores that did not meet the minimum financial performance criteria). We learned that in new markets, and particularly in a difficult economic environment, we initially required a larger population of our core demographic consumer to achieve our financial objectives. In conjunction with the store closures, we realigned our field organization and streamlined our workforce. As a result of these fiscal 2001 restructuring initiatives, we recorded a pre-tax restructuring charge of $21.2 million, including lease termination costs of $13.7 million, inventory liquidation costs of $2.9 million, fixed asset write-downs of $2.1 million, employee termination costs of $1.2 million and other costs of $1.3 million. As of April 25, 2003, we had closed all of these under-performing stores and successfully terminated the lease obligations of 21 stores. In light of the favorable experience related to the costs of closing these stores, we reduced the reserve for the fiscal 2001 restructuring initiatives by approximately $5.0 million during the fourth quarter of fiscal 2002. During fiscal 2002, we continued to experience declining transaction counts, declining purchase size, increased competition, rising operating costs and a slow economy. These factors were exacerbated by the lingering effects of the September 11 terrorist attacks and fear of war in Iraq. We have 59 stores that are near military bases or the Mexican border that have been negatively impacted due to increased security at border crossings and troop mobilizations. We have experienced some significant changes in our senior management team in fiscal 2002. In November 2002, we announced the appointment of our current Chairman and Chief Executive Officer, William R. Fields. In addition, we appointed Melvin Redman, Executive Vice President - Store Operations and Distribution; Larry Kelley, Executive Vice President - Merchandising and Marketing; and Edward Wong, Executive Vice President - Supply Chain and Information Technology. In December 2002, we announced the fiscal 2002 restructuring initiatives needed to improve operating results. These initiatives included the closure of another 23 under-performing stores and consolidation of both the Company's distribution center network and corporate overhead structure. Included in these 23 stores identified for closing, seven represented management's decision to discontinue operations in Louisiana and Tennessee. The consolidation of the Company's distribution center network and corporate overhead structure is a result of the anticipated opening of a new 600,000 square foot distribution center in San Diego, California, and the planned reduction in store base. In connection with the fiscal 2002 restructuring, we recorded a pre-tax restructuring charge of approximately $14.4 million, including lease termination costs of approximately $6.5 million, inventory liquidation costs of approximately $1.1 million, fixed asset write-downs of approximately $5.0 million, employee termination costs of approximately $1.0 million and other costs of approximately $0.8 million. We also announced efforts to liquidate our slow-moving and aged inventory chain-wide. We incurred a pre-tax charge of $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance. 18 As a result of our financial results over the past two fiscal years, bankruptcy filings by a number of well-known retail chains during calendar year 2002 and the general weak economic environment, shortly after the Christmas selling season we experienced a tightening of credit extended to us by vendors, factors and others for merchandise purchases. The initial impact of this credit tightening was a disruption of product flow to our stores in January, February and to a lesser extent March of 2003. This credit environment required us, in many cases, to meet accelerated payment terms in order to re-establish a consistent flow of product and assure a level of inventory for Spring 2003 business. The acceleration of payment terms, in turn, adversely affected our liquidity and, to some extent, further weakened our existing credit standing. In an effort to improve our liquidity position, obtain more reasonable credit terms and provide for a consistent flow of merchandise to our stores, we initiated a series of financing transactions, as well as initiated steps to accelerate the recognition of tax loss carry-back benefits. On March 6, 2003, we completed the private offering of approximately 2.5 million shares of our common stock for an aggregate gross proceeds of approximately $5.7 million, net of placement fees. In addition, during March of 2003, we received an $8.2 million federal tax refund as a result of utilizing a tax loss carry-back benefit. On April 10, 2003, we completed a $7.5 million debt financing transaction consisting of a $6.5 million junior term note secured primarily by inventory and a $1.0 million term note secured primarily by equipment and other assets. We also anticipate completing a sale/leaseback transaction covering distribution equipment to be located in our new Otay Mesa distribution center of between $3.0 million and $4.0 million in May 2003. In April 2003, we have experienced an improved flow of merchandise product to our stores, a loosening of credit from the credit community and improved liquidity as a result of our capital raising efforts. To a large extent, our ability to obtain merchandise in the future under credit terms that we have received historically will depend upon our ability to improve future operating results, including as measured by comparable store sales growth and improved operating margins. Critical Accounting Policies The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities and disclosures 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. Specifically, we must make estimates in the following areas: o Inventory valuation. Merchandise inventory is stated at the lower of cost or market determined using the retail inventory method ("RIM") on a first-in, first-out basis. Under the RIM, the valuation of inventory at cost and the resulting gross margin are calculated by applying a computed cost-to-retail ratio to the retail value of inventory. RIM is an averaging method that has been widely used in the retail industry due to its practicality. Also, it is recognized that the use of the RIM will result in valuing inventory at the lower of cost or market if markdowns are currently taken as a reduction of the retail value of inventory. Inherent in the RIM calculation are certain significant management judgments and estimates regarding markdowns and shrinkage, which may from time to time cause adjustments to the gross margin in the subsequent period. Factors that can lead to distortion in the calculation of the inventory balance include applying the RIM to a group of merchandise items that is not fairly uniform in terms of its cost and selling price relationship and turnover, and applying RIM to transactions over a period of time that includes different rates of gross profit, such as those relating to seasonal merchandise items. To minimize the potential of such distortions in the valuation of inventory from occurring, we utilize 83 sub-departments in which fairly homogeneous classes of merchandise items having similar gross margin are grouped. In addition, failure to take markdowns currently may result in an overstatement of cost under the lower of cost or market principle. As of February 1, 2003, we had an inventory valuation allowance of approximately $8.4 million, which represents our estimate of the cost in excess of the net realizable value of all clearance items. We believe that our RIM provides an inventory valuation that reasonably approximates cost and results in carrying inventory at the lower of cost or market. 19 o Valuation of goodwill, intangible and other long-lived assets. We use certain assumptions in establishing the carrying value and estimated lives of our long-lived assets and goodwill. The criteria used for these evaluations include management's estimate of the asset's continuing ability to generate income from operations and positive cash flows. If assets are considered to be impaired, the impairment recognized is measured by the amount that the carrying value of the assets exceeds the fair value of the assets. Useful lives and related depreciation or amortization expense are based on our estimate of the period that the assets will generate revenues or otherwise be used in operations. Factors that would influence the likelihood of a material change in our reported results include a significant decline in our stock price and market capitalization compared to our net book value, significant changes in an asset's ability to generate positive cash flows, significant changes in our strategic business objectives and utilization of the asset. o Accrued restructuring costs. We have estimated amounts for the charges and the related liabilities regarding our fiscal 2002 and fiscal 2001 restructuring initiatives including store closures, realignment of our field organization and workforce reductions in accordance with the Emerging Issues Task Force ("EITF") Issue 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." Depending on our ability to dispose of the remaining lease obligations for the store and distribution center closures, the actual costs to complete the restructuring initiatives may be different from our estimated costs. o Litigation reserves. Based in part on the advice of our legal counsel, estimated amounts for litigation and claims that are probable and can be reasonably estimated are recorded as liabilities in the balance sheet. The likelihood of a material change in these estimated reserves would be dependent on new claims as they may arise and the favorable or unfavorable outcome of the particular litigation. We continuously evaluate the adequacy of these reserves and, as new facts come to light, adjust these reserves when necessary. o Workers' compensation accrual. At the beginning of fiscal 2001, we transitioned to a partially self-insured workers' compensation program. The program for the policy year ended January 31, 2002 had both a specific and aggregate stop loss amount of $250,000 and $3.2 million, respectively. The program for the policy year ended January 31, 2003 had a specific stop loss amount of $250,000 with no aggregate stop loss limit. We utilize internal actuarial methods, as well as an independent third-party actuary for the purpose of estimating ultimate costs for a particular policy year. Based on these actuarial methods along with current available information and insurance industry statistics, the ultimate expected losses for the policy year ended January 31, 2003 and 2002 were estimated to be approximately $3.4 million and $3.7 million ($3.2 million aggregate stop loss), respectively. Our estimate is based on average claims experience in our industry and our own experience in terms of frequency and severity of claims, with no explicit provision for adverse fluctuation from year to year and is subject to inherent variability. This variability may lead to ultimate payments being either greater or less than the amounts presented above. 20 o Valuation of deferred income taxes. Valuation allowances are established, if deemed necessary, to reduce deferred tax assets to the amount expected to be realized. The likelihood of a material change in our expected realization of these assets is dependent on future taxable income, our ability to use the net operating loss carryforwards, the effectiveness of our tax planning and strategies among the various tax jurisdictions that we operate in, and any significant changes in the tax treatment we currently receive. Results of Operations We define our fiscal year by the calendar year in which most of our business activity occurs (the fiscal year ended February 1, 2003 is referred to as fiscal 2002). The following table sets forth operating data expressed as a percentage of net sales for the fiscal years indicated. Due to operational and strategic changes, year-to-year comparisons of financial results may not be meaningful and the historical results of our operations may not be indicative of our future results. Fiscal Year ----------- 2002 2001 2000 ---- ---- ---- (percentage of net sales) Net sales 100.0 100.0 100.0 Cost of sales 69.7 66.4 64.5 ----- ----- ----- Gross profit 30.3 33.6 35.5 Selling and administrative expenses 36.6 32.4 27.7 Pre-opening expenses 0.2 0.5 1.0 Amortization of intangibles - 0.3 0.4 Restructuring charge 1.9 3.2 - Condemnation award - - (0.2) Stock-based compensation expense - 0.1 0.9 ----- ----- ----- Operating income (loss) (8.4) (2.9) 5.7 Interest expense, net 0.3 0.2 0.3 ----- ----- ----- Income (loss) before income taxes (8.7) (3.1) 5.5 Income taxes (benefit) (3.4) (1.2) 1.6 ----- ----- ----- Net income (loss) (5.3) (1.9) 3.8 ----- ----- -----
Fiscal 2002 Compared to Fiscal 2001 As of February 1, 2003, we operated 244 stores compared to 279 stores at February 2, 2002. In fiscal 2002, we opened 12 new stores and closed 47 stores. In fiscal 2001, we opened 39 new stores and closed three stores. The average number of stores in operation in fiscal 2002 was 259 versus 262 in fiscal 2001. Net sales were $535.3 million for fiscal 2002 compared to $580.5 million for fiscal 2001, a decrease of $45.2 million or 7.8%. Comparable store sales decreased 7.7% in fiscal 2002 versus a decrease of 8.7% in fiscal 2001. The decrease in net sales was due to fewer stores in operation as well as negative comparable store sales. Comparable store sales decreased primarily as a result of continuing slow economy, threat of terrorist attacks, threat of war with Iraq, increased price competition, and to a lesser extent, increased utilities and fuel costs in California, our largest market. As a result of these factors, we experienced fewer transactions and a reduced purchase size. Compounding this, apparel is considered a deferrable purchase for our core customers who have limited discretionary income. Apparel and houseware purchases may be reduced and deferred in favor of more current needs such as food, housing, utilities and transportation. Gross profit was $162.4 million for fiscal 2002 compared to $195.1 million for fiscal 2001, a decrease of $32.7 million or 16.8%. As a percentage of net sales, gross profit was 30.3% in fiscal 2002 compared to 33.6% in fiscal 2001, or a 330 basis-point decline versus fiscal 2001. Included in fiscal 2002 cost of sales were (1) a non-cash charge of $16.1 million related to clearing slow-moving inventory and an inventory valuation allowance, (2) a non-cash charge of $1.1 million related to the expected inventory liquidation cost for store closings identified in the previously mentioned fiscal 2002 restructuring, and (3) a non-cash adjustment of $1.3 million to reduce excess reserve for inventory liquidation cost related to stores closed under the fiscal 2001 restructuring plan. The inventory valuation allowance represented a "lower of cost or market" adjustment related to approximately $16.3 million of aged and slow-moving items that we decided to liquidate by April 2003. As previously reported, the fiscal 2001 gross margin reflected a non-cash charge of $2.9 million related to the 21 estimated inventory liquidation cost for the closing of 28 under-performing stores identified in the fiscal 2001 restructuring plan. After giving effect to restructuring charges in both years, gross profit margin declined primarily due to higher markdown volume (260 basis points). The higher markdown volume was related to a very heavy promotional environment and clearance of slow-moving and aged merchandise. Selling and administrative expenses were $196.4 million for fiscal 2002 compared to $188.3 million for fiscal 2001, an increase of $8.1 million or 4.3%. As a percentage of net sales, selling and administrative expenses were 36.6% for fiscal 2002 compared to 32.4% for fiscal 2001. The increase in selling and administrative spending as a percentage of net sales was both spending related and sales volume related. Included in fiscal 2002 selling and administrative expenses were (1) consulting fees of $2.8 million in connection with a consulting agreement, which was terminated in November 2002, (2) a charge of $2.1 million recorded during the second quarter in conjunction with the settlement of litigation, (3) a non-cash charge of $1.2 million to adjust the value of certain shareholders' notes receivable, and (4) a non-cash valuation allowance of $1.0 million for an uncollectible note receivable due from one of our vendors. In addition to these items, we experienced an increase of approximately $3.5 million in advertising expense. The higher advertising expense was due to increased advertising circulars in response to a very competitive promotional environment. Other store selling expenses, which included store labor and store occupancy, were lower than fiscal 2001 primarily due to the lower average number of stores in operation. Pre-opening expenses were $1.1 million for fiscal 2002 compared to $3.1 million for fiscal 2001, a decrease of $2.0 million, or 64.8%. The decrease in pre-opening expenses was primarily related to 12 new store openings this year versus 39 new store openings last year. Current year pre-opening expenses included a $250,000 lease termination fee for a store we decided not to open. Amortization of intangibles was not recorded for fiscal 2002 compared to $1.7 million for fiscal 2001. The change was due to the elimination of goodwill amortization in conjunction with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 142 and cessation of amortization associated with prior business acquisitions. During the fourth quarter of this year, we recorded a charge of $14.4 million in relation to our previously announced fiscal 2002 restructuring efforts. The charge of $14.4 million included a non-cash inventory liquidation cost of $1.1 million, which was included in cost of sales. In addition, as a result of favorable experience related to the costs of closing the 28 stores included in our fiscal 2001 restructuring plan, we recorded a favorable adjustment of approximately $5.0 million to reduce the reserve established for the fiscal 2001 restructuring plan. Included in this reserve reduction was $1.3 million related to inventory liquidation cost, which was reported as part of cost of sales. As such, the total amount reported as a restructuring charge for fiscal 2002 was $9.9 million versus $18.3 million for fiscal 2001. The restructuring charge of $18.3 million in fiscal 2001 was part of the $21.2 million charge related to our restructuring initiatives, as previously discussed. We recorded $2.9 million of the pre-tax $21.2 million charge as a non-cash inventory liquidation cost which was included in cost of sales. We recorded non-cash stock-based compensation expense related to certain performance-based stock options during fiscal 2001 in the amount of $456,000. During the second quarter of fiscal 2001, we removed the market price hurdle of $49.78 for 19,361 stock options held by a former Executive Vice President who retired in August 2001. As a result of the removal of the market price hurdle, we incurred a non-cash charge of $456,000. There was no stock-based compensation expense incurred in fiscal 2002. Interest expense, net was $1.6 million in fiscal 2002 versus $960,000 in fiscal 2001, an increase of $651,000 or 67.8%. The increase was due to higher average outstanding borrowings on the revolving credit facility. We recorded a federal and state income tax benefit of $18.2 million in fiscal 2002 versus $6.9 million in fiscal 2001, an increase of $11.3 million or 165.0%. The increase was due to an increased pre-tax loss incurred in the current year compared to the prior year. 22 Fiscal 2001 Compared to Fiscal 2000 As of February 2, 2002, we operated 279 stores compared to 243 stores as of February 3, 2001. In fiscal 2001, we opened 39 new stores and closed 3 stores. In fiscal 2000, we opened 70 stores and closed 12 stores. Fiscal 2001 was a 52-week fiscal year as compared to a 53-week fiscal year for fiscal 2000. Net sales were $580.5 million for fiscal 2001 compared to $555.7 million for fiscal 2000, an increase of $24.8 million or 4.5%. Excluding the extra week of sales (53rd week) in fiscal 2000, net sales for fiscal 2001 increased 6.1%. Comparable store sales decreased 8.7% in fiscal 2001 versus an increase of 4.4% in fiscal 2000. The increase in net sales was related to new store growth offset by negative comparable store sales. The average number of stores in operation was 262 for fiscal 2001 compared to 215 for fiscal 2000, an increase of 21.7%. Comparable store sales decreased primarily, we believe, due to a slow economy, increased competition, the effects of September 11 terrorist attacks, and to a lesser extent, increased utilities and fuel costs in California, our largest market. These factors weighed heavily on our core customers and resulted in reduced traffic counts. Compounding this, apparel and housewares are deferrable purchases for our core customers who have limited discretionary income. Apparel and houseware purchases may be reduced or deferred in favor of more current needs such as food, housing, utilities and transportation. In addition, we experienced a promotional and competitive holiday season. The highly promotional environment was evidenced by the post-Thanksgiving offerings by many big box discounters, which enticed consumers in with "close to cost or below cost" items in the electronics and hard goods categories. Gross profit was $195.1 million for fiscal 2001 compared to $197.3 million for fiscal 2000, a decrease of $2.2 million or 1.1%. The fiscal 2001 gross profit reflected a non-cash charge of $2.9 million related to the anticipated inventory liquidation cost for the closing of the 28 under-performing stores as previously mentioned. As a percentage of net sales, gross profit was 33.6% in fiscal 2001 compared to 35.5% in fiscal 2000. After giving effect for the non-cash charge, the decline in gross profit percentage was primarily attributable to higher markdown volume, partially offset by improved initial markup and favorable distribution costs. The higher markdown volume was related to a very heavy promotional environment during the holiday season and earlier clearance of merchandise than a year ago. Selling and administrative expenses were $188.3 million for fiscal 2001 compared to $154.4 million for fiscal 2000, an increase of $33.9 million or 22.0%. As a percentage of net sales, selling and administrative expenses were 32.4% for fiscal 2001 compared to 27.8% for fiscal 2000. The increase in selling and administrative spending as a percentage of net sales was both spending related and sales volume related. The unfavorable spending variance was primarily due to higher store labor, store occupancy and advertising expenses. The increase in store labor was primarily due to minimum wage increases for both hourly and salaried associates, higher health care and workers' compensation costs. The increase in store occupancy was due to higher rent and depreciation expense for new stores. The increase in advertising was due to increased promotional activity based on competition in the marketplace. Pre-opening expenses were $3.1 million for fiscal 2001 compared to $5.4 million for fiscal 2000, a decrease of $2.3 million, or 42.5%. The decrease in pre-opening expenses was related to 39 new store openings in fiscal 2001 versus 70 new store openings in fiscal 2000, as well as $1.0 million recorded in fiscal 2000 associated with the opening of our distribution center in Lewisville, Texas, which became fully operational in February 2001. Amortization of intangibles was $1.7 million for fiscal 2001 compared to $2.1 million for fiscal 2000. The reduction in amortization of $410,000 represented the cessation of amortization associated with certain costs incurred in the ownership change of the company in fiscal 1997. The restructuring charge of $18.3 million was part of the total $21.2 million charge related to our restructuring initiatives, as previously discussed. We recorded $2.9 million of the pre-tax $21.2 million charge as a non-cash inventory liquidation cost which was included in cost of sales. 23 We recorded a non-recurring gain of $1.2 million during fiscal 2000 related to a condemnation award from the City of San Diego for a store located in downtown San Diego, California. We recorded non-cash stock-based compensation expense related to certain performance-based stock options during fiscal 2001 in the amount of $456,000 compared to $4.8 million for fiscal 2000. During the second quarter of fiscal 2001, we removed the market price hurdle of $49.78 for 19,361 stock options held by a former Executive Vice President who retired in August 2001. As a result of the removal of the market price hurdle, we incurred a non-cash charge of $456,000. In fiscal 2000, we recorded non-cash stock-based compensation expense in the amounts of $2.7 million in July 2000 and $2.1 million in August 2000 when stock options with market price hurdles of $24.89 and $33.19, respectively, became exercisable. Interest expense, net was $960,000 in fiscal 2001 versus $1.5 million in fiscal 2000, a decrease of $586,000 or 37.9%. The decrease was attributable to lower average borrowings and lower interest rates under our revolving credit facility and interest income received from the Internal Revenue Service related to tax refund due for prior years. We recorded a federal and state income tax benefit of $6.9 million in fiscal 2001 and a federal and state income tax provision of $9.1 million in fiscal 2000. The income tax benefit was due to the loss we incurred in fiscal 2001. The income tax provision recorded in fiscal 2000 included a favorable adjustment of $2.9 million to our income tax provision for a reduction in our tax valuation allowance and recognition of additional net operating loss carry forwards. Liquidity and Capital Resources General We finance our operations through credit provided by vendors and other suppliers, amounts available under our $50.0 million revolving credit facility, internally generated cash flow and other financing resources. Credit terms provided by vendors and other suppliers are generally net 30 days. Amounts that may be borrowed under the revolving credit facility are based on a percentage of eligible inventories and receivables, as defined, outstanding from time-to-time. At February 1, 2003, we were in compliance with all financial covenants, as defined, and had outstanding borrowings of $6.3 million and letters of credit of $5.1 million under our revolving credit facility. At February 1, 2003, based on eligible inventory and accounts receivable, we were eligible to borrow $32.5 million under our revolving credit facility and had $13.6 million available for future borrowings after giving effect for the $7.5 million availability block, as defined. Since February 1, 2003, we have completed, or expect to complete, a series of financing transactions designed to add liquidity and strengthen our financial position. These financing transactions should, provided we do not experience continued comparable store sales declines and a tightening of credit from our vendors and/or the credit community, along with our $50.0 million revolving credit facility, provide sufficient funds to finance our operations and capital expenditures, pay our debt obligations, and complete the closing of stores and distribution centers included in our fiscal 2002 restructuring and fiscal 2001 restructuring efforts over the next twelve months. On March 6, 2003, we completed the private offering of approximately 2.5 million shares of our common stock for aggregate proceeds of approximately $5.7 million, net of placement fees. On April 10, 2003, we completed a $7.5 million debt financing transaction, which consists of a $6.5 million junior term note secured primarily by inventory and accounts receivable and a $1.0 million term note secured primarily by equipment and other assets. In addition, we received a federal tax refund of $8.2 million in March 2003. We also anticipate completing a sale/leaseback transaction covering distribution equipment to be located in our new Otay Mesa distribution center of between $3.0 million and $4.0 million in the second quarter of fiscal 2003. 24 At April 25, 2003, we were in compliance with all financial covenants, as defined, and had outstanding borrowings of $7.4 million and letters of credit of $12.3 million under our revolving credit facility. In addition, based on eligible inventory and accounts receivable, we were eligible to borrow $45.0 million under our revolving credit facility and had $17.8 million available for future borrowings after giving effect for the $7.5 million availability block, as defined. Cash Flows In fiscal 2002, net cash used in operating activities was $8.1 million versus $26.9 million generated in fiscal 2001. The decrease in cash flow from operating activities was primarily due to the higher cumulative operating loss and the reduced number of days payables outstanding this year. In fiscal 2002 and 2001, cash used in investing activities was $11.0 million and $12.7 million, respectively. Fiscal 2002's investing activities were related to capital expenditures for the development of our new Otay Mesa distribution center, new stores development, replacement capital for existing stores, information system hardware upgrades and replacements, and other general corporate purposes. In fiscal 2002, our financing activities produced a net cash flow of $5.2 million, including $6.3 million of net borrowings on our revolving credit facility, $918,000 in proceeds from the exercise of stock options, partially offset by $2.0 million in repayments of our junior subordinated notes and capital lease obligations. In fiscal 2001, we used $1.5 million for our financing activities, including a payment of $2.2 million for our junior subordinated notes and capital lease obligations, partially offset by $523,000 in proceeds from the exercise of stock options. Revolving Credit Facility We have a $50.0 million revolving credit facility with a financial institution. Under this revolving credit facility, we may borrow up to 70% of our eligible inventory and 85% of our eligible accounts receivable, as defined, up to $50.0 million. The credit facility also included a $15.0 million sub-facility for letters of credit. In September 2002, we extended the term of this revolving credit facility until March 2006. As of February 1, 2003, interest on the credit facility was at the prime rate plus 0.50%, or at our election, LIBOR plus 2.50%. Under the terms of the credit facility, the interest rate may increase or decrease subject to earnings before interest, tax obligations, depreciation and amortization expense (EBITDA), as defined, on a rolling four fiscal quarter basis. Accordingly, prime rate borrowings could range from prime to prime plus 1.00% and LIBOR borrowings from LIBOR plus 1.50% to LIBOR plus 3.00%. The revolving credit facility provides for a $7.5 million availability block against our availability calculation as defined. We are obligated to pay fees equal to 0.125% per annum on the unused amount of the credit facility. The credit facility is secured by a first lien on accounts receivable and inventory. On February 14, 2003, we obtained the approval from the lender to expand the scope of the collateral securing the obligations and increased the sub-facility for letters of credit to $15.0 million. In addition, we obtained the lender's consent to the incurrence by us of up to $10.0 million in additional indebtedness, which may be secured by a junior lien on the collateral. At February 1, 2003, we were in compliance with all financial covenants, as defined, and had outstanding borrowings of $6.3 million and letters of credit of $5.1 million under our revolving credit facility. At February 1, 2003, based on eligible inventory and accounts receivable, we were eligible to borrow $32.5 million under our revolving credit facility and had $13.6 million available after giving effect for the $7.5 million availability block, as defined. On April 10, 2003, we amended the terms of our revolving credit facility to add $7.5 million of term loans, to add one financial covenant, and to amend certain reporting provisions and other terms. The term loans consist of a $6.5 million junior term note secured primarily by inventory and accounts receivable and a $1.0 million term note secured primarily by equipment and other assets. These notes bear interest at the rate of 14.50% per annum on the then current outstanding balance, and mature on April 10, 2004. The $6.5 million junior term note can be extended for one additional year. The financial covenant, which is related to achieving a minimum earnings before interest, tax obligations, depreciation and amortization expense (EBITDA), as defined, is subject to testing only if the Triggering Availability, as defined, is less than $10.0 million on the last three days of each month commencing on May 3, 2003. This financial covenant will terminate at such time that the $7.5 million term loans are no longer outstanding. At April 25, 2003, we were in compliance with all financial covenants, as defined, and had outstanding borrowings of $7.4 million and letters of credit of $12.3 million under our revolving credit facility. In addition, based on eligible inventory and accounts receivable, we were eligible to borrow $45.0 million under our revolving credit facility and had $17.8 million available for future borrowings after giving effect for the $7.5 million availability block, as defined. 25 Junior Subordinated Notes The Junior Subordinated Notes are non-interest bearing and are reflected on our balance sheets at the present value using a discount rate of 10%. As of February 1, 2003, the Junior Subordinated Notes had a face value of $11.3 million and a related unamortized discount of $1.9 million, resulting in a net carrying value of $9.4 million. The discount is amortized to interest expense as a non-cash charge until the notes are paid in full. We made a principal payment on the Junior Subordinated Notes of $2.0 million in January 2003. Additional principal payments are scheduled on December 31, 2003 ($3.0 million), December 31, 2004 ($3.0 million) and a final payment on May 28, 2005 ($5.3 million). Capital Expenditures We anticipate capital expenditures of approximately $5.0 million in fiscal 2003, which includes costs to open new stores, replacement capital for existing stores, information systems software upgrades and hardware replacement and development of our new San Diego distribution center. This new distribution center, projected to open during the second quarter of fiscal 2003, will be approximately 600,000 square feet and will have the capability to service up to 400 stores. The total capital expenditures for this facility will be approximately $4.5 million, of which we have already paid approximately $4.0 million. Store Closures and Restructuring Initiatives In fiscal 2002, we closed a total of 47 stores; 28 of them were under-performing stores identified in our fiscal 2001 restructuring initiatives, 13 of them were under-performing stores identified in our fiscal 2002 restructuring initiatives, and six of them were due to lease expirations. Subsequent to February 1, 2003, we closed two under-performing stores identified in our fiscal 2002 restructuring initiatives. In addition, we have decided to keep operating two of the under-performing stores as a result of entering into agreements with the landlords to reduce the rent expense for these two locations. We plan to close the remaining six under-performing stores identified in our fiscal 2002 restructuring initiatives by January 2004. The majority of the store closures were part of our restructuring initiatives intended to improve future financial performance. The cash charges to close a store principally consisted of lease termination or sublease costs, employee severance and tear-down costs. In addition to the closing of under-performing stores, we also included the realignment of our field organization and workforce reductions as part of our restructuring initiatives. As of April 25, 2003, we had substantially completed the realignment and workforce reductions in our field organization and corporate overhead structure. Upon the opening of the new San Diego distribution center during the second quarter of fiscal 2003, we will close the two existing San Diego distribution facilities. The next distribution consolidation initiative will be to transfer our Texas distribution function to the new San Diego distribution center. We are currently marketing our Texas distribution facility and intend to close this facility if we are able to successfully terminate our lease or sublet the facility. No date for this closure has been established. Currently, we estimate the cash requirement in fiscal 2003 related to our restructuring efforts will be approximately $11.1 million. We believe that our sources of cash, including the revolving credit facility and other financing resources, should be adequate to fund our restructuring cash requirements. 26 Contractual Obligations and Commitments The following table summarizes, as of February 1, 2003, certain of our contractual obligations, as well as estimated cash requirements related to our restructuring initiatives. This table should be read in conjunction with "Note 2 Fiscal 2002 Restructuring Charge", "Note 3 Fiscal 2001 Restructuring Charge", "Note 8 Long-Term Debt and Revolving Credit Facility" and "Note 10 Lease Commitments" in the accompanying financial statements. Junior Subordinated Operating Restructuring Notes Leases Charges Total ------------- --------- ------------- ----- Fiscal Year: 2003 $ 3,000 $ 29,903 $ 11,117 $ 44,020 2004 3,000 27,626 1,747 32,373 2005 5,300 24,264 - 29,564 2006 - 18,111 - 18,111 2007 - 13,076 - 13,076 Thereafter - 44,422 - 44,422 ------------- --------- ------------- --------- Total $ 11,300 $ 157,402 $ 12,864 $ 181,566 ------------- --------- ------------- ---------
Recent Accounting Pronouncements In April 2002, the Financial Accounting Standards Board (the "FASB") issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections", which rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt" and an amendment of that Statement, and SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." SFAS No. 145 also rescinds SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers." SFAS No. 145 amends SFAS No. 13, "Accounting for Leases", to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. We do not expect the adoption of this statement will have a material impact on our financial position or results of operations. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", which addresses significant issues regarding the recognition, measurement, and reporting of costs associated with exit and disposal activities, including restructuring activities. This statement requires that costs associated with exit or disposal activities be recognized when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is effective for all exit or disposal activities initiated after December 31, 2002. We do not expect the adoption of this statement will have a material impact on our financial position or results of operations. In November 2002, the FASB issued Interpretation No. ("FIN") 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45"), which requires elaborating on the disclosures that must be made by a guarantor in financial statements about its obligations under certain guarantees. It also requires that a guarantor recognize, at the inception of certain types of guarantees, a liability for the fair value of the obligation undertaken in issuing the guarantee. The disclosure requirements of FIN 45 are effective for financial statements issued after December 15, 2002, and have been applied in the presentation of the accompanying consolidated financial statements. The recognition requirements of FIN 45 are applicable for guarantees issued or modified after December 31, 2002. We have not yet determined the effect, if any, the recognition requirement for guarantees issued or modified after December 31, 2002 will have on our business, results of operations and financial condition. 27 In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." SFAS No. 148 amends SFAS No. 123, "Accounting for Stock-Based Compensation" to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. We will continue to apply the disclosure-only provisions of SFAS No. 123. Furthermore, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. Certain of the disclosure modification are required for fiscal years ending after December 15, 2002. We adopted the annual disclosure provision of SFAS No. 148 for our fiscal 2002 ended February 1, 2003. The interim disclosure provisions are effective for financial reports containing condensed financial statements for interim periods beginning after December 15, 2002. We will adopt the disclosure requirement for interim financial statements in the first quarter of fiscal 2003. In January 2003, the FASB issued FIN 46 - "Consolidation of Variable Interest Entities." FIN 46 clarifies the application of Accounting Research Bulletin No. 51 - Consolidated Financial Statements to those entities defined as "Variable Interest Entities" (more commonly referred to as special purpose entities) in which equity investors do not have the characteristics of a "controlling financial interest" or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to all Variable Interest Entities created after January 31, 2003, and by the beginning of the first interim or annual reporting period commencing after June 15, 2003 for Variable Interest Entities created prior to February 1, 2003. Item 7A. Quantitative and Qualitative Disclosures About Market Risk We are exposed to interest rate risk on our fixed rate debt obligations. At February 1, 2003, fixed rate debt obligations totaled approximately $11.3 million. The fixed rate debt obligations are non-interest bearing and are discounted at a rate of 10%, resulting in a net carrying value of $9.4 million. Maturities are $3.0 million, $3.0 million and $5.3 million in fiscal 2003, 2004 and 2005, respectively. While generally an increase in market interest rates will decrease the value of this debt, and decreases in rates will have the opposite effect, we are unable to estimate the impact that interest rate changes will have on the value of this debt as there is no active public market for the debt and we are unable to determine the market interest rate at which alternate financing would have been available at February 1, 2003. 28 Item 8. Financial Statements and Supplementary Data INDEX TO FINANCIAL STATEMENTS Page - ----------------------------- ---- FACTORY 2-U STORES, INC. Report of Independent Public Accountants F-1 Report of Independent Public Accountants (Arthur Andersen LLP) F-2 Balance Sheets as of February 1, 2003 and February 2, 2002 F-3 Statements of Operations for Fiscal Years Ended February 1, 2003, February 2, 2002 and February 3, 2001 F-5 Statements of Stockholders' Equity for Fiscal Years Ended February 1, 2003, February 2, 2002 and February 3, 2001 F-6 Statements of Cash Flows for Fiscal Years Ended February 1, 2003, February 2, 2002 and February 3, 2001 F-7 Notes to Financial Statements F-9 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure On April 24, 2002, the Board of Directors of the Company, on the recommendation of the Audit Committee, determined not to renew the engagement of its independent public accountants, Arthur Andersen LLP ("Andersen"), for the fiscal year ended February 1, 2003. During the Company's fiscal years ended February 2, 2002 and February 3, 2001, and the subsequent interim period through April 24, 2002, there were no disagreements between the Company and Andersen on any matter of accounting principles or practices, financial statement disclosures, or auditing scope or procedure, which disagreements, if not resolved to the satisfaction of Andersen, would have caused Andersen to make reference to the matter of the disagreement in connection with their reports. Andersen's reports on the Company's financial statements for each fiscal year ended February 2, 2002 and February 3, 2001 did not contain an adverse opinion or disclaimer of opinion, nor were they qualified or modified as to uncertainty, audit scope or accounting principles. Andersen's report on the Company's financial statements for the fiscal year ended February 2, 2002, dated February 27, 2002, was issued on an unqualified basis in conjunction with the filing of Factory 2-U's Annual Report on Form 10-K for the fiscal year ended February 2, 2002 filed on April 19, 2002 with the Securities and Exchange Commission. None of the reportable events described under Item 304 (a) (1) (v) of Regulation S-K occurred within Factory 2-U's two most recent fiscal years and subsequent interim period through April 24, 2002. 29 PART III Item 10. Directors and Executive Officers of the Registrant Directors The following table sets forth as of April 25, 2003 certain information concerning our directors. Served on the Expiration of Name Age Position Board Since Term as Director ---- --- -------- ------------- ---------------- Peter V. Handal 60 Director 1997 2004 Ronald Rashkow 62 Director 1997 2004 Wm. Robert Wright II 35 Director 1998 2004 William R. Fields 53 Director, Chairman of the Board 2002 2005 and Chief Executive Officer Willem F.P. de Vogel 52 Director 2000 2003
Peter V. Handal has been a director since February 1997. Mr. Handal is President and Chief Executive Officer of Dale Carnegie & Associates. Since 1990, he has been President of COWI International Group (a management consulting firm). Mr. Handal is also Chief Executive Officer of J4P Associates LP (a real estate developer). He serves on the Board of Directors of Dale Carnegie & Associates, Cole National Corporation and W. Kruk, S.A. Ronald Rashkow was appointed by the Board of Directors to the position of Lead Director effective November 2002. Mr. Rashkow has been a director since February 1997. He has been a principal of Chapman Partners, L.L.C., an investment banking firm, since its founding in September 1995. For more than five years prior to that, he served as Chief Executive Officer and Chairman of the Board of Directors of Handy Andy Home Improvement Centers, Inc. (a building supply retailer started by his family in 1946). Wm. Robert Wright II has been a director since November 1998. He has been a managing partner of Grey Mountain Partners, LLC, a private equity firm that invests in middle market companies, since its founding in January 2003. Prior to that, he was employed by TCR from 1992 through 2002, except for a period from July 1993 to August 1995 when he was in a graduate program at Harvard University. His last position with TCR was "managing partner", a title he held from 1999 to 2002. William R. Fields has been a director, Chairman of the Board and Chief Executive Officer since November 2002. Prior to joining us, from 1999 to October 2002, Mr. Fields served as Chairman and Chief Executive Officer of Apec China Asset Management, Ltd. From 1997 to 1999, he served as President and Chief Executive Officer of Hudson's Bay Company. Prior to that, from 1996 to 1997, Mr. Fields served as Chairman and Chief Executive Officer of Blockbuster Entertainment Group. From 1993 to 1996, Mr. Fields served as President and Chief Executive Officer of Wal-Mart Stores Division. Mr. Fields currently serves on the Boards of Directors of Lexmark International, a publicly traded company, and The University of Texas Pan-American Foundation. Willem F.P. de Vogel has been a director since December 2000. Mr. de Vogel has served as the President of Three Cities Research, Inc., a firm engaged in the investment and management of private capital, since 1982. 30 Executive Officers The following table sets forth as of April 25, 2003 certain information concerning our executive officers at the end of fiscal 2002, who are not directors. Name Age Position Officer Since ---- --- -------- ------------- Norman G. Plotkin 49 Executive Vice President - Store 1998 Development, Human Resources and General Counsel Douglas C. Felderman 50 Executive Vice President and 1999 Chief Financial Officer Michael J. Hein 54 Senior Vice President - 2002 Distribution and Transportation Edward Wong 46 Executive Vice President - 2002 Supply Chain and Information Technology Larry I. Kelley 58 Executive Vice President - 2003 Merchandising and Marketing Melvin C. Redman 52 Executive Vice President - Store 2003 Operations and Distribution
Norman G. Plotkin is Executive Vice President - Store Development, Human Resources and General Counsel. In addition to his responsibilities of Store Development and General Counsel, Mr. Plotkin assumed responsibility over Human Resources as of January 2003. Mr. Plotkin joined us in July 1998 in the position of Senior Vice President - Store Development and General Counsel. Prior to joining us, Mr. Plotkin was the President of Normark Real Estate Services, Ltd., a commercial real estate firm based in Des Plaines, Illinois. Prior to that, from 1988 until 1996, Mr. Plotkin was the Senior Vice President of Finance and Administration and General Counsel of Handy Andy Home Improvement Centers, Inc. Douglas C. Felderman is Executive Vice President and Chief Financial Officer. Mr. Felderman joined us in May 1999. Prior to joining us, from July 1997 to May 1999, Mr. Felderman served as Senior Vice President - Finance and Chief Financial Officer of Strouds, Inc. and from 1995 to 1997, he was the Vice President - Finance of Strouds, Inc. Mr. Felderman served as Vice President, Chief Financial Officer for Crocodile Enterprises, Inc. from April 1994 to September 1995 (a restaurant operator of casual full service and quick service restaurants). From September 1990 to April 1994, he was a business consultant. Michael J. Hein is Senior Vice President - Distribution and Transportation. Mr. Hein joined us in March 2000 as Vice President of Transportation and Distribution and served in that position until his promotion to Senior Vice President of Distribution and Transportation in August 2002. Prior to joining us, from April 1995 to March 2000, Mr. Hein served as the Director of Distribution for Petco Animal Supplies, Inc. Edward Wong is Executive Vice President - Supply Chain and Information Technology. Mr. Wong joined us in May 2002 as Vice President - Planning and Allocation and was promoted to his current position in August 2002. Prior to joining us, from July 2001 to May 2002, Mr. Wong served as the Vice President of Solution Design for ProfitLogic, Inc. From January 2001 to May 2001, he served as Vice President, Retail Engagement Executive for i2 Technologies. From August 1998 to December 2000, Mr. Wong served as Senior Vice President of Supply Chain and Technology for Gymboree Corporation. Prior to that, Mr. Wong served as Divisional Vice President of Retail Planning and Allocation for Eddite Bauer, Inc. from May 1997 to July 1998. 31 Larry I. Kelley is Executive Vice President - Merchandising and Marketing. Mr. Kelley joined us in January 2003. Prior to joining us, from February 2001 to December 2002, Mr. Kelley served as a principal of Renaissance Partners, LC, a consulting firm for the retail industry. Mr. Kelley served as President and Chief Executive Officer for One Price Clothing Stores from May 1997 through January 2001. From April 1991 through April 1997, Mr. Kelley served as President and Chief Executive Officer of Casual Male Big and Tall, a retail apparel chain. Melvin C. Redman is Executive Vice President - Store Operations and Distribution. Mr. Redman joined us in January 2003. Prior to joining us, from October 1995 to January 2003, Mr. Redman served as President and Managing Partner of Redman and Associates, a management consulting firm. Mr. Redman was the President and Chief Operating Officer of MSC Industrial Supply from January 1999 to March 1999. From October 1991 to June 1995, Mr. Redman was the Senior Vice President of Store Operations for Wal*Mart Stores and from December 1984 to October 1991 he was the Regional Vice President of Store Operations for Wal*Mart Stores. Item 11. Executive Compensation Compensation of Directors We pay each director who is not an employee of ours or of TCR an annual fee of $12,000 plus $1,250 for attendance at each meeting of the Board of Directors. In addition, at the end of each fiscal quarter, we grant each director who is not an employee 250 shares of common stock. Prior to June 19, 2002, at the end of each fiscal quarter, we also granted each director who is not an employee options to purchase 500 shares of our common stock. Since June 19, 2002, the directors who were not employees of the Company, no longer received quarterly grants of options to purchase our common stock, but instead received at the end of each fiscal quarter, a cash payment equal to the closing market price on such date times 500. Mr. Rashkow received the above-described compensation until November 4, 2002 when he was appointed to the position of Lead Director, at which time he received the compensation described below. We reimburse all directors for any out-of-pocket travel expenses incurred in attending meetings. Ronald Rashkow Lead Director Agreement On November 4, 2002, Mr. Rashkow was appointed to the newly created position of Lead Director by our Board of Directors under the terms of an agreement. Mr. Rashkow's service as Lead Director will continue at the pleasure of the Board of Directors for up to three years. Under the terms of his agreement, Mr. Rashkow receives monthly compensation of $12,500, plus reimbursement of all reasonable out-of-pocket travel and other expenses related to the performance of his duties as Lead Director. He is also entitled to receive $3,500 per day, plus reimbursement of all reasonable out-of-pocket travel and other expenses related to the performance of his duties as Lead Director, for each day of service in excess of six days per quarter. As an inducement to secure his services as Lead Director, Mr. Rashkow also received options to purchase 50,000 shares of our common stock at an exercise price of $1.61, the fair market value of our common stock on the date of grant. The options vested immediately and are exercisable for five years from the date of grant. As a further inducement to secure his services, Mr. Rashkow also received 25,000 shares of restricted common stock, subject to his completion of 12 months of service as Lead Director. Mr. Rashkow has a target grant of 25,000 similar shares of restricted common stock, subject to his completion of 24 months of service, and another 25,000 shares subject to his completion of 36 months of service. His receipt of these restricted shares, in addition to the length of service requirement, will be commensurate with our Chief Executive Officer's achievement of his performance goals for the applicable year. 32 Compensation of Executive Officers Employment Contracts with Named Executive Officers Compensation of the Chief Executive Officer Mr. Fields' annual base salary is $750,000, which the Compensation Committee believes is commensurate with the salaries paid to other executives with similar experience in comparable companies. We base Mr. Fields' annual bonus on the achievement of corporate objectives set annually by the Compensation Committee after consultation with Mr. Fields. William Fields Employment Agreement We employed Mr. Fields, Chairman of our Board of Directors and Chief Executive Officer, pursuant to a one-year employment agreement dated November 7, 2002 that expires on November 6, 2003, provided that at the scheduled end of the initial employment term, and on each anniversary thereafter, his employment term will be automatically extended for an additional one-year period unless either Mr. Fields or we give notice to the other at least 90 days before an extension is to take effect that either does not desire the employment term to be extended. Under the employment agreement, Mr. Fields' base salary is $750,000 annually. For the first year of his employment term, Mr. Fields is entitled to a bonus of $375,000, payable in 12 monthly installments. Mr. Fields was required to prepare and present to the Compensation Committee written performance objectives for the fiscal year ending January 31, 2004. Following approval by the Compensation Committee of the performance objectives, Mr. Fields' target bonus for the fiscal year ending January 31, 2004 is 75% of his annual base salary for that year. For each subsequent fiscal year in which he meets performance objectives approved in advance by the Compensation Committee, Mr. Fields' target bonus will be based on 100% of his base salary in effect as of the start of that fiscal year. As an inducement necessary to secure his services, we granted Mr. Fields non-qualified options to purchase 250,000 shares of our common stock at an exercise price per share of $1.68, the fair market value of our stock on the date of grant. These options vest in tranches of 15,625 shares on each December, March, June and September 30 during the first four years of his employment term. The options in each tranche will be exercisable for a period of five years after the vesting of that tranche. In the event that an amendment to our stock option plan has not been approved by our stockholders, we are nevertheless contractually obligated with respect to such options which would not be granted under our stock option plan. As a further inducement necessary to secure his services, we also granted Mr. Fields 250,000 restricted shares of our common stock for $2,500. The restricted stock will vest in installments as follows: 83,333 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period; an additional 83,333 shares will vest when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 83,334 shares will vest when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Fields' right to receive any shares of restricted stock that have not vested prior to November 7, 2007 will terminate and the restricted stock will be returned to us. Mr. Fields will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the effective date of his employment agreement. In the event that an amendment to our stock option plan has not been approved by our stockholders, we are nevertheless contractually obligated with respect to such stock which would not be granted under our stock option plan. Melvin Redman Employment Agreement We employed Melvin Redman, Executive Vice President - Store Operations and Distribution, pursuant to a one-year employment agreement dated January 6, 2003 that expires on January 6, 2004, provided that at the scheduled end of the initial employment term, and on each anniversary thereafter, his employment term will be automatically extended for an additional one-year period unless either Mr. Redman or we give notice to the other at least 90 days before an extension is to take effect that either does not desire the employment term to be extended. 33 Under the employment agreement, Mr. Redman's base salary is $500,000 annually. Mr. Redman received a signing bonus in the amount of $100,000. Mr. Redman was required to prepare and present to the Chief Executive Officer written performance objectives for the fiscal year ending January 31, 2004. Following approval by the Chief Executive Officer of the performance objectives, Mr. Redman's target bonus for the fiscal year ending January 31, 2004 is 50% of his annual base salary for that year. For each subsequent fiscal year in which he meets performance objectives approved in advance by the Compensation Committee, Mr. Redman's target bonus will be based on 50% of his base salary in effect as of the start of that fiscal year. If the performance objectives accepted by the Chief Executive Officer are exceeded in any year, the annual bonus will be increased by 1% of his base salary for each 1% of excess, up to a maximum bonus of 100% of his base salary for the achievement of 150% of the performance objectives. If the performance objectives are not met, Mr. Redman will not be entitled to any bonus. As an inducement necessary to secure his services, we granted Mr. Redman non-qualified options to purchase 125,000 shares of our common stock at an exercise price per share of $3.13, the fair market value of our stock on the date of grant. These options vest in tranches of 7,812.5 shares on each December, March, June and September 30 during the first four years of his employment term. The non-qualified options in each tranche will be exercisable for a period of five years after the vesting of that tranche. In the event that an amendment to our stock option plan has not been approved by our stockholders, we are nevertheless contractually obligated with respect to such options which would not be granted under our stock option plan. As a further inducement necessary to secure his services, we also granted Mr. Redman 125,000 restricted shares of our common stock for $1,250. The restricted stock will vest in installments as follows: 41,666.7 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period; an additional 41,666.7 shares will vest when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 41,666.7 shares will vest when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Redman's right to receive any shares of restricted stock that has not vested prior to January 6, 2008 will terminate and the restricted stock will be returned to us. Mr. Redman will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the effective date of his employment agreement. In the event that an amendment to our stock option plan has not been approved by our stockholders, we are nevertheless contractually obligated with respect to such stock which would not be granted under our stock option plan. Larry Kelley Employment Agreement We employed Larry Kelley, Executive Vice President - Merchandising and Marketing, pursuant to a one-year employment agreement dated January 6, 2003 that expires on January 6, 2004, provided that at the scheduled end of the initial employment term, and on each anniversary thereafter, his employment term will be automatically extended for an additional one-year period unless either Mr. Kelley or we give notice to the other at least 90 days before an extension is to take effect that either does not desire the employment term to be extended. Under the employment agreement, Mr. Kelley's base salary is $400,000 annually. Mr. Kelley was required to prepare and present to the Chief Executive Officer written performance objectives for the fiscal year ending January 31, 2004. Following approval by the Chief Executive Officer of the performance objectives, Mr. Kelley's target bonus for the fiscal year ending January 31, 2004 is 50% of his annual base salary for that year. For each subsequent fiscal year in which he meets performance objectives approved in advance by the Compensation Committee, Mr. Kelley's target bonus will be based on 50% of his base salary in effect as of the start of that fiscal year. If the performance objectives accepted by the Chief Executive Officer are exceeded in any year, the annual bonus will be increased by 1% of his base salary for each 1% of excess, up to a maximum bonus of 100% of his base salary for the achievement of 150% of the performance objectives. If the performance objectives are not met, Mr. Kelley will not be entitled to any bonus, except that Mr. Kelley will receive a minimum annual bonus of $100,000 for the fiscal year ending January 31, 2004, payable in twelve equal monthly installments beginning February 2003 as long as Mr. Kelley remains employed by us. 34 As an inducement to secure his services, we granted Mr. Kelley non-qualified options to purchase 75,000 shares of our common stock at an exercise price per share of $3.13, the fair market value of our stock on the date of grant. These options vest in tranches of 4,687.5 shares on each March, June, September and December 30 during the first four years of his employment term. The options in each tranche will be exercisable for a period of five years after the vesting of that tranche. In the event that an amendment to our stock option plan has not been approved by our stockholders, we are nevertheless contractually obligated with respect to such options which would not be granted under our stock option plan. As a further inducement to secure his services, we also granted Mr. Kelley 75,000 restricted shares of our common stock for $750. The restricted stock will vest in installments as follows: 25,000 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period, an additional 25,000 shares will vest when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 25,000 shares will vest when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Kelley's right to receive any shares of restricted stock that has not vested prior to January 6, 2008 will terminate and the restricted stock will be returned to us. Additionally, Mr. Kelley will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the effective date of his employment agreement. In the event that an amendment to our stock option plan has not been approved by our stockholders, we are nevertheless contractually obligated with respect to such stock which would not be granted under our stock option plan. Severance Agreements Michael Searles Severance Agreement On November 7, 2002, Mr. Searles' employment with us was terminated without cause. Under the terms of his Amended Employment Agreement with us, he is entitled to twelve months of his base salary in the total amount of $750,000. He is also entitled to all accrued but unpaid compensation, vacation pay and reimbursable business expenses through his termination date, payable in a lump sum. In addition, he is entitled to the amounts or benefits owing under benefit plans and policies, exclusive of cash severance policies and up to three years of COBRA premiums. As of April 25, 2003, Mr. Searles has received $319,731 in severance payments. All of Mr. Searles' stock options expired three months after his termination date. On November 7, 2002, Mr. Searles resigned as a member of the Board of Directors. Spencer Insolia Severance Agreement On January 6, 2003, Mr. Insolia's employment as Executive Vice President - Marketing and Chief Strategy Officer with us was terminated. Under the terms of his severance agreement, Mr. Insolia received an initial payment of $3,846. He is also to receive a stream of bi-weekly payments through July 18, 2003, totaling $128,654, unless he becomes employed prior to that date. If he becomes employed prior to July 18, 2003, any payments we would otherwise be obligated to pay him will be reduced by the amount of compensation he receives for services performed through July 18, 2003. We also paid Mr. Insolia bonuses totaling $137,500 to which he was entitled on January 6, 2003 and agreed to pay Mr. Insolia's COBRA premiums through July 2003. 35 Louis Leidelmeyer Severance Agreement On January 6, 2003, Mr. Leidelmeyer's employment as Executive Vice President - Human Resources with us was terminated. Under the terms of his severance agreement, Mr. Leidelmeyer is entitled to a sum equal to his annual base salary in the amount of $225,000 and his annual automobile allowance in effect at the time of his termination, both payable in equal bi-weekly installments. If he becomes employed prior to January 6, 2004, any payments we would otherwise be obligated to pay him will be reduced by the amount of compensation he receives for services performed through January 6, 2004. He was also entitled to all accrued but unpaid vacation pay, payable in a lump sum. In addition, we agreed to pay Mr. Leidelmeyer's COBRA premiums for twelve months following the termination of his employment. As of April 25, 2003, Mr. Leidelmeyer has received $67,038 in severance payments. Compensation Committee Report on Executive Compensation The Compensation Committee of the Board of Directors is composed entirely of outside directors. The Compensation Committee is responsible for establishing and administering the compensation policies applicable to our executive officers. All decisions by the Compensation Committee are subject to review and approval by the full Board of Directors. Our executive compensation philosophy and specific compensation plans tie a significant portion of executive compensation to our success in meeting specific profit, growth and performance goals. Our compensation objectives include attracting and retaining the best possible executive talent, motivating executive officers to achieve our performance objectives, rewarding individual performance and contributions, and linking executives' and stockholders' interests through equity based plans. Our executive compensation consists of three key components: base salary, annual incentive compensation and stock options, each of which is intended to complement the others and, taken together, to satisfy our compensation objectives. The Compensation Committee's policies with respect to each of the three components are discussed below. Base Salary. In the early part of each fiscal year, the Compensation Committee reviews the base salary of the Chief Executive Officer (subject to requirements of his employment agreement) and the recommendations of the Chief Executive Officer with regard to the base salary of all other executive officers, and approves, with any modifications it deems appropriate, annual base salaries for each of our executive officers. We base the recommended base salaries of the executive officers on an evaluation of the individual performance of the executive officer, including satisfaction of annual objectives. The recommended base salary of the Chief Executive Officer is based on achievement of our annual goals relating to financial objectives, including earnings growth and return on capital employed, and an evaluation of individual performance. Recommended base salaries of the executive officers are also based in part upon an evaluation of the salaries of executives who hold comparable positions at comparable companies. Annual Incentive Compensation. Our executive officers participate in a discretionary incentive bonus plan which provides for the payment of annual bonuses in cash or stock (or both), based on our success in attaining financial objectives, and subjective factors established from time to time by the Compensation Committee or the Board of Directors. With the exception of those executives who have separate employment agreements with us, the Compensation Committee normally considers aggregate incentive cash and stock bonus payments to the executive officers, as a group, of up to 50% of their base salaries, and any bonus payments in excess of 50% of the aggregate base salaries, may be paid in cash or stock, at the discretion of the Compensation Committee. The Compensation Committee did not award annual incentive bonus payments to any of our executive officers for fiscal 2002. Stock Options. The primary objective of the stock option program is to link our interests and those of our executive officers and other selected employees to those of the stockholders through significant grants of stock options. The Compensation Committee bases the aggregate number of options it recommends on practices of comparable companies, while grants of stock options to specific employees reflect their expected long-term contribution to our success. Compensation Committee: Willem F.P. de Vogel, Chairman Peter V. Handal 36 Compensation Committee Interlocks and Insider Participation No member of the Compensation Committee of the Board of Directors was, during fiscal 2002 or at any other time, one of our officers or employees or an officer or employee of our subsidiaries. Summary of Cash and Other Compensation The following table contains information about the compensation during fiscal 2002 of our former principal executive officer, current principal executive officer, each of our four other most highly paid executive officers who served as executive officers at the end of fiscal 2002 and two other named executive officers who were not serving as executive officers at the end of fiscal 2002:
SUMMARY COMPENSATION TABLE Long-Term Compensation Fiscal Restricted Securities All Other Name and Principal Year Annual Compensation Stock Underlying Compensation Position (1) Salary ($) Bonus ($) Award(s) ($) Options ($) (3) -------- --- ---------- --------- ------------ ---------- ------------ Michael M. Searles 2002 $ 605,769 $ - $ - - $ 390,777 Former President, Chief 2001 747,564 - - - 206,532 Executive Officer and 2000 600,000 300,000 - - 210,005 Chairman of the Board(4) William R. Fields 2002 158,754 62,500 417,500 250,000 40,328 Chief Executive Officer - - - - - - and Chairman of the - - - - - - Board(5) Douglas C. Felderman 2002 285,000 94,271 - - 987 Executive Vice President 2001 283,250 - - - 66,195 and 2000 241,346 125,000 - 19,474 310,127 Chief Financial Officer Michael J. Hein 2002 147,308 - - - 875 Senior Vice President - - - - - - - - Distribution and - - - - - - Transportation Spencer Insolia (6) 2002 196,154 137,500 - 60,000 37,786 Executive Vice President - - - - - - - -Marketing and Chief - - - - - - Strategy Officer Louis A. Leidelmeyer (7) 2002 212,730 - - 5,000 39,135 Executive Vice President - - - - - - - Human Resources - - - - - - Norman G. Plotkin 2002 285,000 112,468 - - 2,200 Executive Vice President - 2001 282,500 - - - 15,689 Store Development and 2000 222,884 117,500 - 21,262 13,501 General Counsel Edward Wong 2002 165,500 25,000 - 36,000 7,355 Executive Vice President - - - - - - - Supply Chain and Technology - - - - - - - --------------------------------------------------------------------------------------------------------- (1) We refer to a fiscal year by the year in which most of the activity occurred (for example, we refer to fiscal year ended February 1, 2003 as fiscal 2002). (2) The aggregate amount of other annual compensation is less than the lesser of $50,000 or 10% of such person's total annual salary and bonus. 37 (3) "All Other Compensation" for fiscal 2002 includes (i) matching contributions under our 401(k) Savings Plan of $2,200 for Mr. Searles, $987 for Mr. Felderman, $875 for Mr. Hein, $1,289 for Mr. Leidelmeyer and $2,200 for Mr. Plotkin; (ii) forgiveness of interest in the amount of $157,808 for Mr. Searles; (iii) reimbursement of moving expenses of $40,328 to Mr. Fields and $7,355 to Mr. Wong; (iv) cost of living adjustment of $18,771 for Mr. Insolia; (v) final vacation pay of $86,538 for Mr. Searles, $28,615 for Mr. Leidelmeyer and $5,553 for Mr. Insolia; and (vi) severance payments of $144,231 for Mr. Searles, $13,462 for Mr. Insolia and $9,231 for Mr. Leidelmeyer. (4) Mr. Searles was President, Chief Executive Officer and Chairman of the Board until his termination of employment on November 7, 2002. (5) Mr. Fields was appointed Chief Executive Officer and Chairman of the Board effective November 7, 2002. During fiscal 2002, Mr. Fields received $62,500 of his guaranteed first year bonus of $375,000 under the terms of his employment agreement. Mr. Fields received a restricted stock grant of 250,000 shares of common stock on November 7, 2002 when the closing market price of our common stock was $1.68 per share. The restricted shares vest as follows: 83,333 shares when the closing market price of our common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period, an additional 83,333 shares will vest when the closing market price of our common stock equals or exceeds $20 per share for 20 consecutive trading days in any three-month period; and 83,334 shares will vest when the closing market price equals or exceeds $30 per share for 20 consecutive trading days in any three-month period. Mr. Fields' right to receive any shares of restricted stock that have not vested prior to November 7, 2007 will terminate and the restricted stock will be returned to us. Additionally, Mr. Fields will not be entitled to sell any vested shares of restricted stock until the expiration of two years from the effective date of his employment agreement. Mr. Fields is entitled to receive dividends that are paid on common stock and he has the right to vote his restricted shares. As of February 1, 2003, the value of Mr. Fields' restricted stock holdings was $677,500 (which is calculated as 250,000 shares times $2.72 per share, minus the $2,500 that Mr. Fields paid for the stock). (6) As of January 6, 2003, Mr. Insolia was no longer an employee. (7) As of January 6, 2003, Mr. Leidelmeyer was no longer an employee.
38 Grants of Stock Options The following table sets forth information concerning the award of stock options during fiscal 2002. We have never granted stock appreciation rights. Potential Realizable % of Total Value at Assumed Number of Options Annual Rates of Securities Granted to Exercise Stock Price Appreciation Underlying Employees or Base For Option Term (1) Options in Fiscal Price Expiration ------------------------ Name Granted (#) Year ($/Share) Date 5% ($) 10%($) ---- ----------- --------- --------- ---------- ------ ------ Michael M. Searles (2) - - - - - - William R. Fields 250,000 30.96% $ 1.68 9/29/2011 $ 231,558 $ 570,338 Douglas C. Felderman - - - - - - Michael J. Hein - - - - - - Spencer Insolia (3) 60,000 7.43% 15.62 3/19/2012 589,400 1,493,655 Louis A. Leidelmeyer (3) 5,000 0.62% 2.81 9/18/2012 8,836 22,392 Norman G. Plotkin - - - - - - Edward Wong 18,000 2.23% 12.86 6/19/2012 145,577 368,920 18,000 2.23% 2.81 9/18/2012 31,809 80,611 - ------------------------------------------------------------------------------------------------------------ (1) Amounts shown represent the potential value of granted options if the assumed annual rates of stock appreciation are maintained over the terms of the granted options. The assumed rates of appreciation are established by regulation and are not intended to be a forecast of our performance or to represent our expectations with respect to the appreciation, if any, of the common stock. (2) As of November 7, 2002, Mr. Searles was no longer an employee. (3) As of January 6, 2003, Messrs. Insolia and Leidelmeyer were no longer employees. All such options expired unexercised 60 days after that date.
39 Exercise of Stock Options and Holdings The following table sets forth information concerning exercises of stock options during fiscal 2002 and the fiscal year-end value of unexercised options. We have never granted stock appreciation rights.
Aggregated Option Exercises in Fiscal 2002 Fiscal 2002 Year-End Option Values Number of Securities Underlying Unexercised Value of Unexercised Shares Options at Fiscal Year End In-the-Money Options at Acquired Value (#) Fiscal Year End ($) On Realized -------------------------- ----------------------- Name Exercise ($) Exercisable Unexercisable Exercisable Unexercisable ---- -------- -------- ----------- ------------- ----------- ------------- Michael M. Searles (1) - $ - 283,517 18,080 $ - $ - William R. Fields - - 15,625 234,375 16,250 243,750 Douglas C. Felderman - - 64,315 35,685 - - Michael J. Hein - - 7,200 10,800 - - Spencer Insolia (2) - - - 60,000 - - Louis A. Leidelmeyer (2) - - 20,000 25,000 - - Norman G. Plotkin - - 60,936 26,758 - - Edward Wong - - - 36,000 - - - -------------------------------------------------------------------------------------------------------------- (1) As of November 7, 2002, Mr. Searles was no longer an employee. All such options expired unexercised 3 months after that date. (2) As of January 6, 2003, Messrs. Insolia and Leidelmeyer were no longer employees. All such options expired unexercised 60 days after that date.
Item 12. Security Ownership of Certain Beneficial Owners and Management Principal Stockholders The following persons are known by us, based solely upon information filed by such persons with the Securities and Exchange Commission, to have owned beneficially more than 5% of any class of our voting securities as of the April 25, 2003: Common Stock Name and Address ------------ of Beneficial Owner Number Percent of Class ------------------- ------ ---------------- Three Cities Fund II L.P (1) 1,383,914 8.7% Three Cities Offshore II C.V. (1) 2,340,020 14.6% The TCW Group, Inc. (2) 1,685,050 10.5% Kennedy Capital Management, Inc. (3) 789,900 4.9% Shumway Capital Partners LLC (4) 731,900 4.6% - -------------------------------------------------------------------------------- 40 (1) The address of the beneficial owners is c/o Three Cities Research, Inc., 650 Madison Avenue, New York, NY 10022. As the investment advisor to both Three Cities Fund II L.P. and Three Cities Offshore II C.V., with power to direct voting and disposition by both those Funds, Three Cities Research, Inc. ("TCR") may be deemed to be the beneficial owner of the total 3,723,934 shares owned by both funds. In addition, because Willem F.P. de Vogel is a general partner of TCR Associates, L.P., the general partner of Three Cities Fund II L.P., he may be deemed to be a beneficial owner of the shares owned by Three Cities Fund II L.P. (2) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is 865 South Figueroa Street, Los Angeles, California 90017. The TCW Group, Inc., a Nevada corporation ("TCW"), filed the Schedule 13G on behalf of itself and its direct and indirect subsidiaries, which collectively constitute The TCW Group, Inc. business unit (the "TCW Business Unit"). The TCW Business Unit is primarily engaged in the provision of investment management services. TCW is the parent holding company and its relevant subsidiaries are (i) Trust Company of the West, a California corporation and a bank as defined in Section 3(a)(6) of the Securities Exchange Act of 1934, (ii) TCW Asset Management Company, a California corporation and an investment adviser registered under Section 203 of the Investment Advisers Act of 1940, and (iii) TCW Investment Management Company, a California corporation and an investment adviser registered under Section 203 of the Investment Advisers Act of 1940. As of July 6, 2001, the ultimate parent company of TCW is Societe Generale, S.A., a corporation formed under the laws of France ("SG"). The principal business of SG is acting as a holding company for a global financial services group, which includes certain distinct specialized business units that are independently operated, including the TCW Business Unit. S.G., for purpose of the federal securities laws, may be deemed ultimately to control TCW and the TCW Business Unit. SG, its executive officers and directors, and its direct and indirect subsidiaries (including all business units except the TCW Business Unit), may beneficially own shares of the securities of the issuer to which this schedule relates and such shares are not reported in this statement. In accordance with Securities and Exchange Commission Release No. 34-39538 (January 12, 1998), and due to the separate management and independent operation of its business units, SG disclaims beneficial ownership of shares beneficially owned by the reporting person. The reporting person disclaims beneficial ownership of shares beneficially owned by SG and any of SG's other business units. (3) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is 10829 Olive Blvd., St. Louis, MO 63141. Kennedy Capital Management, Inc. filed its Schedule 13G with the SEC on February 18, 2003 and claimed beneficial ownership of 789,900 shares, or 6% of our common stock. (4) Based solely on our review of the Schedule 13G filed by such stockholder with the SEC: The address of the beneficial owner is 600 Steamboat Rd., Greenwich, CT 06830. Shumway Capital Partners LLC filed its Schedule 13G with the SEC on February 28, 2003 and claimed beneficial ownership of 731,900 shares, or 5.5% of our common stock. The statement was filed by Shumway Capital Partners LLC ("SCP"), a limited liability company organized under the laws of the State of Delaware, which serves as the investment manager to SCP Domestic Fund, LP ("SCP-D"), a Delaware limited partnership and SCP Overseas Fund, Ltd. ("SCP-O"), a Cayman Islands exempted company, with respect to the shares of common stock directly owned by them. SCP exercises investment discretion with regard to the common stock held by SCP-D and SCP-O. The statement was also filed by Chris W. Shumway ("Mr. Shumway"), with respect to the shares of common stock directly owned by SCP by virtue of SCP having investment discretion over the accounts of SCP-D and SCP-O.
On April 25, 2003, The Depository Trust Company owned of record 9,384,384 shares of common stock, constituting 58.68% of our outstanding common stock. We understand those shares were held beneficially for members of the New York Stock Exchange, some of whom may in turn have been holding shares beneficially for customers. 41 Management Stockholders As of April 25, 2003, our directors and executive officers beneficially owned the following amounts of our voting securities: Amount and Nature of Beneficial Percent of Name of Beneficial Owner Ownership (1) Class ------------------------ ------------- ---------- Willem F.P. de Vogel (2) 8,552 * Douglas C. Felderman 88,620 * William R. Fields 281,250 1.8% Peter V. Handal 93,146 * Michael J. Hein 11,091 * Larry I. Kelley 79,687 * Norman G. Plotkin 96,078 * Ronald Rashkow (3) 318,506 2.0% Melvin C. Redman 132,812 * Edward Wong 3,600 * Wm. Robert Wright II 12,589 * Directors and Officers as a Group (11 persons) 1,125,931 7.0% - ---------------------------------------------------------------------------- * Less than 1%. (1) Includes shares which may be acquired within 60 days through the exercise of stock options or warrants, as follows: Mr. de Vogel, 3,000 shares; Mr. Felderman, 80,210 shares; Mr. Fields, 31,250 shares; Mr. Handal, 8,129 shares; Mr. Hein, 10,800; Mr. Kelley, 4,687 shares; Mr. Plotkin, 72,188 shares; Mr. Rashkow, 56,500 shares; Mr. Redman, 7,812 shares; Mr. Wong, 3,600 shares; and Mr. Wright, 7,000 shares; all officers and directors as a group, 285,176 shares. (2) Does not include shares owned by Three Cities Fund II L.P. Mr. de Vogel is a general partner of TCR Associates, L.P., the general partner of Three Cities Fund II L.P. TCR, of which Mr. de Vogel is the president, is the advisor to Three Cities Fund II L.P. and to Three Cities Offshore II C.V., which own a total of 3,723,934 shares, and has the power to direct the voting and disposition of those shares. (3) Includes 57,091 shares of common stock held by members of Mr. Rashkow's family, 458 shares of common stock held by a limited partnership of which Mr. Rashkow is the general partner and 56,500 shares which Mr. Rashkow may acquire within 60 days through the exercise of stock options.
Item 13. Certain Relationships and Related Transactions Transactions with Management In March 1997, we entered into an agreement for TCR to act as our financial advisor. Under this agreement, we pay TCR an annual fee of $50,000 and reimburse TCR all of its out-of-pocket expenses incurred for services rendered, up to an aggregate of $50,000 annually. We reimbursed TCR for out-of-pocket expenses in the amounts of $47,000, $34,000 and $37,000 during fiscal 2002, 2001 and 2000, respectively. 42 On March 6, 2003, Three Cities Fund II L.P. purchased 240,793 shares of our common stock and Three Cities Offshore II C.V. purchased 407,207 shares of our common stock in a private placement at a purchase price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $1,782,000. TCR controls approximately 23.3% of our outstanding common stock and Mr. de Vogel, a member of our Board of Directors, is the President of TCR. Also on March 6, 2003, Mr. Rashkow purchased 72,700 shares of our common stock in the private placement at a price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $199,925. Indebtedness of Management During fiscal years 1997 and 1998, we sold to our executive management shares of our Series B Preferred Stock, which were subsequently converted to common stock. With the exception of Mr. Searles, each of the executives paid for his or her shares by giving us a full-recourse promissory note secured by the purchased stock. Each note accrues interest at 8% per annum and requires principal payments equivalent to 16.25% of the annual bonus paid to the purchaser (if such bonus is actually paid in a given year) and a balloon payment of the unpaid principal and interest at maturity. Each of the notes matures five years after the date it was made. Mr. Searles' promissory note in the principal amount of $1,400,000 is partial- recourse and was due on April 29, 2003. Mr. Searles is liable for the payment of principal and accrued but unpaid interest on his note up to $600,000 (including the value of the shares of our stock securing the note) and we will have the right to retain the stock securing his note with respect to the balance of any principal and accrued interest on his note to the extent such stock has a value in excess of $600,000 (but not in excess of the outstanding balance of principal and accrued interest). We had forgiven interest payments aggregating $157,808 through November 7, 2002, but Mr. Searles' note accrued interest from November 7, 2002 to April 29, 2003. On April 29, 2003, the principal and accrued interest due on Mr. Searles' note was $1,458,608 and we foreclosed on the collateral which had a market value of $1,198,750, resulting in a deficiency of $259,858, for which Mr. Searles does not have personal liability for this deficiency under the terms of the note. Mr. Plotkin's promissory note was outstanding during fiscal 2002, but as of March 21, 2003, Mr. Plotkin had repaid his promissory note in full in the amount of $101,008. Additionally, on April 29, 2003, the principal and accrued interest due on the notes for Tracy W. Parks, our former Executive Vice President and Chief Operating Officer, was $117,042. On April 29, 2003, we foreclosed on the collateral which had a market value of $82,197, resulting in a deficiency of $34,845, for which Mr. Parks is personally liable under the terms of his notes. During fiscal 2002, we loaned Spencer Insolia, our former Executive Vice President - Marketing and Chief Strategy Officer, $100,000 at the time of his hire. Mr. Insolia's promissory note accrued interest at a rate of 7% per annum and was to be paid in two installments of $50,000 plus all accrued interest to date, on May 1, 2003 and May 1, 2004. Under the terms of his note, Mr. Insolia paid the entire balance of $105,619 on January 6, 2003, when he ceased to be employed by us. Item 14. Controls and Procedures Evaluation. Within 90 days prior to the date of this Annual Report on Form 10-K, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures as defined under Rule 13a-14 and Rule 15d-14 of the Securities Exchange Act of 1934, as amended. This evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (CEO) and Chief Financial Officer (CFO). Limitations. Our management, including the CEO and CFO, does not expect that our disclosure controls and procedures will necessarily prevent all errors. Such controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that their objectives are met. 43 Conclusions. Based upon our evaluation, we have concluded that, subject to the limitations noted above, our disclosure controls and procedures are effective to ensure that material information relating to the Company is made known to management, including the CEO and CFO, particularly during the period when our periodic reports are being prepared. Changes in Internal Controls. There have not been any significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of our last evaluation of such internal controls, including any corrective actions with regard to significant deficiencies and material weaknesses. PART IV Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a) 1. Financial Statements. See Index to Financial Statements contained in Item 8. 2. Financial Statement Schedules. Schedule II Valuation and Qualifying Accounts contained on page 45. All other schedules are omitted because of the absence of conditions under which they are required or because the required information is set forth in the financial statements and notes thereto. 3. Exhibits. See Item 15(c). (b) Reports on Form 8-K. Item 5 - On November 19, 2002, we filed a report on Form 8-K regarding the appointment of William R. Fields as Chairman and Chief Executive Officer of the Company effective November 7, 2002 and the appointment of Ronald Rashkow as the Lead Director of the Board of Directors effective November 4, 2002. (c) Exhibits. Reference is made to the Index to Exhibits immediately preceding the exhibits thereto. 44
Schedule II Factory 2-U Stores, Inc. Valuation and Qualifying Accounts Fiscal Year Ended February 1, 2003, February 2, 2002 and February 3, 2001 (in thousands) Additions --------- Balance at Charged to Charged to Balance at Beginning Costs and Other End of Description of Period Expenses Accounts Deductions Period ----------- ---------- ---------- ---------- ---------- ---------- As of February 1, 2003 Notes Receivable Allowance $ - $ 2,340 $ - $ - $ 2,340 Inventory Valuation Allowance 1,152 7,210 - - 8,362 FY02 Restructuring Reserve - 14,398 - (1,987) 12,411 FY01 Restructuring Reserve 21,154 (4,969) - (11,411) 4,774 As of February 2, 2002 Inventory Valuation Allowance $ 1,265 $ - $ - $ (113) $ 1,152 FY01 Restructuring reserve - 21,231 - (77) 21,154 As of February 3, 2001 Inventory Valuation Allowance $ 1,265 $ - $ - $ - $ 1,265
45
Index to Exhibits Exhibit Number Document - ------- -------- 2.1 (1) Plan and Agreement of Merger dated June 18, 1998 between Family Bargain Corporation and General Textiles, Inc. 3.1 (2) (i) Restated Certificate of Incorporation (ii) Bylaws 4.1 (1) Junior Subordinated Note Agreement dated April 30, 1998 among General Textiles, American Endeavour Fund Limited and London Pacific Life & Annuity Company 4.2 (1) Form of Warrant dated April 30, 1998 10.1 (3) Factory 2-U Stores, Inc. Employee Stock Purchase Plan 10.2 (4) Amended and Restated Factory 2-U Stores, Inc. 1997 Stock Option Plan 10.3 (5) Factory 2-U Stores, Inc. Employee Compensation Agreements 10.4 (6) Financing Agreement between The CIT Group/Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of March 3, 2000 10.5 (6) First Amendment to the Financing Agreement between The CIT Group/ Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of March 3, 2000 10.6 (6) Amended Employment Agreement between Factory 2-U Stores, Inc. and Michael M. Searles 10.7 (7) Second Amendment to the Financing Agreement between The CIT Group/ Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of April 10, 2001 10.8 (7) Third Amendment to the Financing Agreement between The CIT Group/ Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of April 9, 2002 10.9 (8) Fourth Amendment to the Financing Agreement between The CIT Group/ Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of September 16, 2002 10.10 * Fifth Amendment to the Financing Agreement between The CIT Group/ Business Credit, Inc. (as Agent and a Lender) and Factory 2-U Stores, Inc. (as Borrower), dated as of February 14, 2003 10.11 * Sixth Amendment to the Financing Agreement by and among The CIT Group/Business Credit, Inc. (as Agent and a Lender), Factory 2-U Stores, Inc. (as Borrower), and GB Retail Funding LLC (a Lender), dated as April 10, 2003 10.12 (9) Employment Agreement, dated as of November 7, 2002, by and between Factory 2-U Stores, Inc. and William R. Fields 10.13 (9) Letter Agreement, dated as of November 4, 2002, by and between Factory 2-U Stores, Inc. and Ronald Rashkow 10.14 * Employment Agreement, dated as of January 6, 2003, by and between Factory 2-U Stores, Inc. and Melvin Redman 10.15 * Employment Agreement, dated as of January 6, 2003, by and between Factory 2-U Stores, Inc. and Larry I. Kelley 10.16 * Industrial/Commercial Single-Tenant Lease as of March 8, 2002, by and between Factory 2-U Stores, Inc. (as Tenant) and ORIX Otay, LLC (as Landlord) 23.1 * Consent of Ernst & Young LLP, Independent Public Accountants 23.2 * Information regarding consent of Arthur Andersen LLP 99.1 ** Certification furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by William R. Fields, Chief Executive Officer 99.2 ** Certification furnished pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 by Douglas C. Felderman, Executive Vice President and Chief Financial Officer - -------------------------------------------------------------------------------- 46 (1) Incorporated by reference to Registration Statement on Form S-2, No. 333-58797 filed with the SEC on October 14, 1998. (2) Incorporated by reference to Registration Statement on Form S-1, No. 33-77448 filed with the SEC on April 7, 1994. (3) Incorporated by reference to Registration Statement on Form S-8 No. 333-94123 filed with the SEC on January 5, 2000. (4) Incorporated by reference to Registration Statement on Form S-8 No. 333-40682 filed with the SEC on June 30, 2000. (5) Incorporated by reference to Registration Statement on Form S-8 No. 333-89267 filed with the SEC on October 19, 1999. (6) Incorporated by reference to Form 10-K for the fiscal year ended January 29, 2000 filed with the SEC on April 24, 2000. (7) Incorporated by reference to Form 10-K for the fiscal year ended February 2, 2002 filed with the SEC on April 19, 2002. (8) Incorporated by reference to Form 10-Q for the quarterly period ended August 3, 2002 filed with the SEC on September 17, 2002. (9) Incorporated by reference to Form 8-K for report dated November 7, 2002 filed with the SEC on November 19, 2002. * Filed herewith. ** Furnished herewith.
47 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned, hereunto duly authorized. FACTORY 2-U STORES, INC. By: /s/ William R. Fields --------------------- William R. Fields Chairman of the Board Dated: May 2, 2003 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of this Company and in the capacities and on the date indicated. Signature Title Date --------- ----- ---- /s/ William R. Fields Chief Executive Officer May 2, 2003 - ------------------------- and Chairman of the Board William R. Fields (Principal Executive Officer) /s/ Douglas C. Felderman Executive Vice President, May 2, 2003 - ------------------------- Chief Financial Officer Douglas C. Felderman (Principal Financial and Accounting Officer) /s/ Ronald Rashkow Lead Director May 2, 2003 - ------------------------- Ronald Rashkow /s/ Willem de Vogel Director May 2, 2003 - ------------------------- Willem de Vogel /s/ Peter V. Handal Director May 2, 2003 - ------------------------- Peter V. Handal /s/ Wm. Robert Wright II Director May 2, 2003 - ------------------------- Wm. Robert Wright II 48 CERTIFICATION I, William R. Fields, certify that: 1. I have reviewed this annual report on Form 10-K of Factory 2-U Stores, Inc. (the "Registrant"). 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report. 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material aspects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this annual report. 4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the Registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrant's ability to record, process, summarize and report financial data and have identified for the Registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls; and 6. The Registrant's other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 2, 2003 /s/ William R. Field -------------------- Name: William R. Fields Title: Chief Executive Officer 49 CERTIFICATION I, Douglas C. Felderman, certify that: 1. I have reviewed this annual report on Form 10-K of Factory 2-U Stores, Inc. (the "Registrant"). 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report. 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material aspects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this annual report. 4. The Registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the Registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; (b) evaluated the effectiveness of the Registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and (c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The Registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the Registrant's auditors and the audit committee of Registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the Registrant's ability to record, process, summarize and report financial data and have identified for the Registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant's internal controls; and 6. The Registrant's other certifying officer and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 2, 2003 /s/ Douglas C. Felderman ------------------------- Name: Douglas C. Felderman Title: Executive Vice President, Chief Financial Officer 50 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and the Board of Directors of Factory 2-U Stores, Inc. We have audited the accompanying balance sheet of Factory 2-U Stores, Inc. (the "Company") as of February 1, 2003 and the related statements of operations, stockholders' equity and cash flows for the year ended February 1, 2003 ("fiscal 2002"). Our audit also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and the financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements and schedule based on our audit. The financial statements and financial statement schedule of the Company for the fiscal years ended February 2, 2002 and February 3, 2001, were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those statements in their report dated February 27, 2002. We conducted our audit in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the fiscal 2002 financial statements referred to above present fairly, in all material respects, the financial position of the Company as of February 1, 2003 and the results of its operations and its cash flows for the year ended February 1, 2003 in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related fiscal 2002 financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note 6 to the financial statements, the Company changed its method of accounting for goodwill and other intangible assets in accordance with Statement of Financial Accounting Standards ("Statement") No. 142 during the first quarter of fiscal 2002. As discussed above, the financial statements of the Company as of February 2, 2002 and February 3, 2001, and for the years then ended were audited by other auditors who have ceased operations. As described in Note 6, these financial statements have been updated to include the transitional disclosures required by Statement No. 142, "Goodwill and Other Intangible Assets," which was adopted by the Company as of February 3, 2002. Our audit procedures with respect to the disclosures in Note 6 for fiscal 2001 and 2000 included (i) agreeing the previously reported net income (loss) to the previously issued financial statements and the adjustments to reported net income (loss) representing amortization expense (including any related tax effects) recognized in those periods related to goodwill that are no longer being amortized to the Company's underlying records obtained from management, and (ii) testing the mathematical accuracy of the reconciliation of adjusted net income (loss) to reported net income (loss), and the related net income (loss)-per-share amounts. In our opinion, the disclosures for fiscal 2001 and 2000 in Note 6 related to the transitional disclosures of Statement 142 are appropriate. However, we were not engaged to audit, review, or apply any procedures to the Company's financial statements for fiscal 2001 and 2000 other than with respect to such disclosures and, accordingly, we do not express an opinion or any other form of assurance on the Company's fiscal 2001 and 2000 financial statements taken as a whole. /s/ ERNST & YOUNG LLP San Diego, California February 24, 2003 F-1 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS THIS IS A COPY OF THE AUDIT REPORT PREVIOUSLY ISSUED BY ARTHUR ANDERSEN LLP IN CONNECTION WITH FACTORY 2-U STORES, INC.'S FILING ON FORM 10-K FOR THE YEAR ENDED FEBRUARY 2, 2002. THIS AUDIT REPORT HAS NOT BEEN REISSUED BY ARTHUR ANDERSEN LLP IN CONNECTION WITH THIS FILING ON FORM 10-K. SEE EXHIBIT 23.2 FOR FURTHER DISCUSSION. THE BALANCE SHEET AS OF FEBRUARY 3, 2001, REFERRED TO IN THIS REPORT HAS NOT BEEN INCLUDED IN THE ACCOMPANYING FINANCIAL STATEMENTS. To Factory 2-U Stores, Inc.: We have audited the accompanying balance sheets of Factory 2-U Stores, Inc. (a Delaware corporation) as of February 2, 2002 and February 3, 2001, and the related statements of operations, stockholders' equity and cash flows for each of the three years in the period ended February 2, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Factory 2-U Stores, Inc. as of February 2, 2002 and February 3, 2001 and the results of its operations and its cash flows for each of the three years in the period ended February 2, 2002 in conformity with accounting principles generally accepted in the United States. Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedule listed in the index to financial statements and supplementary data is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material aspects in relation to the basic financial statements taken as a whole. /s/ ARTHUR ANDERSEN LLP San Diego, California February 27, 2002 F-2
FACTORY 2-U STORES, INC. Balance Sheets (in thousands, except share data) February 1, February 2, 2003 2002 ----------- ----------- ASSETS Current assets: Cash and cash equivalents $ 3,465 $ 17,390 Merchandise inventory 32,171 54,860 Accounts receivable, net 884 2,013 Income taxes receivable 8,200 - Prepaid expenses 5,436 6,357 Deferred income taxes 9,732 3,553 -------- -------- Total current assets 59,888 84,173 Leasehold improvements and equipment, net 28,602 37,042 Deferred income taxes 10,750 7,182 Other assets 963 1,011 Excess of cost over net assets acquired, less accumulated amortization of $13,344 26,301 26,301 -------- -------- Total assets $126,504 $155,709 ======== ========
The accompanying notes are an integral part of these financial statements. F-3
FACTORY 2-U STORES, INC. Balance Sheets (in thousands, except share data) February 1, February 2, 2003 2002 ----------- ----------- LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current maturities of long-term debt and capital lease $ 3,000 $ 2,019 Accounts payable 27,961 36,271 Taxes payable 5,840 3,332 Accrued expenses 27,831 27,918 -------- -------- Total current liabilities 64,632 69,540 Revolving credit facility 6,300 - Long-term debt 6,445 8,376 Accrued restructuring charges 1,747 3,578 Deferred rent 3,061 3,649 -------- -------- Total liabilities 82,185 85,143 -------- -------- Commitments and contingencies Stockholders' equity: Common stock, $0.01 par value; 35,000,000 shares authorized and 13,475,705 shares and 12,842,146 shares issued and outstanding, respectively 135 128 Stock subscription notes receivable (1,116) (2,225) Additional paid-in capital 122,516 121,370 Accumulated deficit (77,216) (48,707) -------- -------- Total stockholders' equity 44,319 70,566 -------- -------- Total liabilities and stockholders' equity $126,504 $155,709 ======== ======== The accompanying notes are an integral part of these financial statements.
F-4
FACTORY 2-U STORES, INC. Statements of Operations (in thousands, except per share data) Fiscal Year Ended ----------------- February 1, February 2, February 3, 2003 2002 2001* ----------- ----------- ----------- Net sales $535,270 $580,460 $555,670 Cost of sales 372,885 385,390 358,393 ----------- ----------- ----------- Gross profit 162,385 195,070 197,277 Selling and administrative expenses (exclusive of non-cash stock-based compensation expense shown below) 196,435 188,272 154,379 Pre-opening expenses 1,086 3,086 5,371 Amortization of intangibles - 1,682 2,092 Restructuring charge 9,914 18,360 - Condemnation award - - (1,240) Stock-based compensation expense - 456 4,807 ----------- ----------- ----------- Operating income (loss) (45,050) (16,786) 31,868 Interest expense, net 1,611 960 1,546 ----------- ----------- ----------- Income (loss) before income taxes (46,661) (17,746) 30,322 Income taxes (benefit) (18,152) (6,850) 9,058 ----------- ----------- ----------- Net income (loss) $(28,509) $(10,896) $ 21,264 =========== =========== =========== Net income (loss) per share Basic $ (2.20) $ (0.85) $ 1.69 Diluted $ (2.20) $ (0.85) $ 1.63 Weighted average common shares outstanding Basic 12,957 12,807 12,589 Diluted 12,957 12,807 13,066 * 53-week fiscal year. The accompanying notes are an integral part of these financial statements.
F-5
FACTORY 2-U STORES, INC. Statements of Stockholders' Equity (in thousands, except share data) Stock Common Stock Subscription Additional ------------ Notes Paid-in Accumulated Shares Amount Receivable Capital Deficit Total ------ ------ ---------- ------- ------- ----- Balance at January 29, 2000 12,390,817 $ 124 $(2,710) $108,091 $(59,075) $46,430 ---------- ------- -------- -------- --------- ------- Issuance of common stock for exercise of stock options 341,932 3 - 2,595 - 2,598 Compensation expense related to performance-based stock options - - - 4,807 - 4,807 Tax effect related to non-qualified stock options - - - 3,454 - 3,454 Issuance of common stock to Board members and management as compensation 19,407 - - 519 - 519 Issuance of common stock under employee stock purchase plan 7,148 - - 180 - 180 Payments of notes receivable - - 485 - - 485 Net income - - - - 21,264 21,264 ----------- ------- -------- -------- --------- ------- Balance at February 3, 2001 12,759,304 127 (2,225) 119,646 (37,811) 79,737 ----------- ------- -------- -------- --------- ------- Issuance of common stock for exercise of stock options 66,456 1 - 522 - 523 Compensation expense related to the removal of price hurdle for performance-based stock options - - - 456 - 456 Tax effect related to non-qualified stock options - - - 389 - 389 Issuance of common stock to Board members as compensation 4,000 - - 106 - 106 Issuance of common stock under employee stock purchase plan 12,386 - - 251 - 251 Net loss - - - - (10,896) (10,896) ----------- ------- -------- -------- --------- --------- Balance at February 2, 2002 12,842,146 128 (2,225) 121,370 (48,707) 70,566 ----------- ------- -------- -------- --------- --------- Issuance of common stock for exercise of stock options 124,764 1 - 917 - 918 Issuance of common stock to Board members and management as compensation 478,000 5 - 78 - 83 Issuance of common stock under employee stock purchase plan 30,795 1 - 151 - 152 Payments of notes receivable - - 76 - - 76 Write-down of stock subscription notes receivable to fair value - - 1,033 - - 1,033 Net loss - - - - (28,509) (28,509) ----------- ------- -------- -------- --------- --------- Balance at February 1, 2003 13,475,705 135 $(1,116) 122,516 $(77,216) $ 44,319 ----------- ------- -------- -------- --------- ---------
The accompanying notes are an integral part of these financial statements. F-6
FACTORY 2-U STORES, INC. Statements of Cash Flows (in thousands) Fiscal Year Ended ----------------- February 1, February 2, February 3, 2003 2002 2001* ----------- ----------- ----------- Cash flows from operating activities Net income (loss) from operating activities $ (28,509) $ (10,896) $ 21,264 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities Depreciation and amortization 15,160 14,773 13,594 Loss on disposal of equipment 76 205 581 Deferred rent expense (550) 264 1,098 Stock-based compensation expense - 456 4,807 Restructuring charge 4,734 4,922 - Other 1,204 - - Changes in operating assets and liabilities Merchandise inventory 22,454 (5,286) (17,396) Prepaid expenses and other assets (15,741) (3,609) (7,984) Accounts payable (8,310) 11,077 5,200 Accrued expenses and other liabilities 1,399 14,967 (3,840) ---------- ---------- ----------- Net cash provided by (used in) operating activities (8,083) 26,873 17,324 ---------- ---------- ----------- Cash flows used in investing activities Purchase of leasehold improvements and equipment (11,001) (12,694) (23,818) ---------- ---------- ----------- Net cash used in investing activities (11,001) (12,694) (23,818) ---------- ---------- ----------- (continued)
The accompanying notes are an integral part of these financial statements. F-7
FACTORY 2-U STORES, INC. Statements of Cash Flows (in thousands) Fiscal Year Ended ----------------- February 1, February 2, February 3, 2003 2002 2001* ----------- ----------- ----------- Cash flows provided by (used in) financing activities Borrowings on revolving credit facility 94,794 88,044 111,711 Payments on revolving credit facility (88,494) (88,044) (111,711) Payments of long-term debt and capital lease obligations (2,019) (2,171) (1,253) Proceeds from issuance of common stock, net 5 160 180 Payments of deferred debt issuance costs (121) (40) (250) Proceeds from exercise of stock options 918 523 2,598 Payments of stock subscription notes receivable 76 - 485 ---------- ---------- ----------- Net cash provided by (used in) financing activities 5,159 (1,528) 1,760 ---------- ---------- ----------- Net increase (decrease) in cash and cash equivalents (13,925) 12,651 (4,734) Cash and cash equivalents at the beginning of the period 17,390 4,739 9,473 ---------- ---------- ----------- Cash and cash equivalents at the end of the period $ 3,465 $ 17,390 $ 4,739 ========== ========== =========== Supplemental disclosure of cash flow information Cash paid during the period for Interest $ 613 $ 387 $ 651 Income taxes $ 1,328 $ 5,698 $ 9,559 Supplemental disclosures of non-cash investing and financing activities Tax effect related to non-qualified stock options $ - $ 389 $ 3,454 Issuance of common stock to board members and management as compensation $ 78 $ 106 $ 519 * 53-week fiscal year. The accompanying notes are an integral part of these financial statements.
F-8 FACTORY 2-U STORES, INC. Notes to Financial Statements 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Description of Business We operate a chain of off-price retail apparel and houseware stores in Arizona, Arkansas, California, Idaho, Nevada, New Mexico, Oklahoma, Oregon, Texas and Washington. We sell branded casual apparel for the family, as well as selected domestics and household merchandise at prices, which generally are significantly lower than other discount stores. At February 1, 2003, we operated 244 stores under the name Factory 2-U. Fiscal Year Our fiscal year is based on a 52/53 week year ending on the Saturday nearest January 31. Fiscal years ended February 1, 2003, February 2, 2002 and February 3, 2001 included 52 weeks, 52 weeks and 53 weeks, respectively. We define our fiscal year by the calendar year in which most of the activity occurs (e.g. the fiscal year ended February 1, 2003 is referred to as fiscal 2002). Cash Equivalents We consider all liquid investments with original maturities of three months or less to be cash equivalents. Merchandise Inventory Merchandise inventory is stated at the lower of cost or market determined using the retail inventory method on a first-in, first-out basis. In addition, consistent with industry practice, we capitalize certain buying, warehousing, storage and transportation costs. At February 1, 2003 and February 2, 2002, such costs included in inventory were $3.4 million and $4.6 million, respectively. As of February 1, 2003 and February 2, 2002, we had an inventory valuation allowance of $8.4 million and $1.1 million, respectively, which represented our estimate of the cost in excess of the net realizable value of all clearance and slow-moving items. Leasehold Improvements and Equipment Leasehold improvements and equipment are stated at original cost less accumulated depreciation and amortization. Tenant improvement allowances, offered by landlords from time to time, are recorded as a reduction to the original cost of leasehold improvements. Equipment under capital leases is stated at the present value of minimum lease payments at the date of acquisition. Depreciation expense for the years ended February 1, 2003, February 2, 2002 and February 3, 2001 was $14.0 million, $14.0 million, and $10.4 million, respectively. We calculate depreciation and amortization using the straight-line method over the estimated useful lives as follows: Leasehold improvements the shorter of the asset's useful life or the lease term, generally five years Furniture, fixtures and three to five years other equipment Excess of Cost over Net Assets Acquired ("Goodwill") At the beginning of fiscal 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, "Goodwill and Other Intangible Assets", which ceases the amortization of goodwill and instead, the carrying value of goodwill will be evaluated for impairment at least annually using a fair value test. As required, we have completed an impairment analysis using present value of future cash flow method and concluded that our goodwill was not impaired as of February 1, 2003. Prior to fiscal 2002, goodwill was amortized on a straight-line basis over 25 years. Goodwill amortization was $1.6 million for each of the fiscal years ended February 2, 2002 and February 3, 2001. F-9 Comprehensive Income We have adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income." This statement establishes the disclosure requirements for comprehensive income and its components within the financial statements. We had no items of comprehensive income for the fiscal years ended February 1, 2003, February 2, 2002 and February 3, 2001. Asset Impairment We assess potential asset impairment in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which establishes an accounting model to be used for long-lived assets to be disposed of by sale or held for use and broadens the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 supersedes SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" and the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions" for the disposal of a segment of a business (as previously defined in that Opinion). The provisions of SFAS No. 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001. This statement retains the requirements of SFAS 121 that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of an asset to be held and used is measured by comparing the carrying amount of the asset to future net cash flows expected to be generated by the asset. If such asset is considered to be impaired, the impairment to be recognized is measured by the amount that the carrying value of the asset exceeds the fair value of the asset. Fair Value of Financial Instruments The carrying amounts of cash and cash equivalents, receivables, payables and accrued expenses approximate fair value due to the short-term nature of such instruments. The carrying amount of the revolving credit facility approximates fair value due to the floating rate on such instrument. The carrying value of long-term debt with fixed payment terms approximates fair value. Self-Insurance We self-insure or retain a portion of the exposure for losses related to workers' compensation and general liability costs. The self-insured policies provide for both specific and aggregate stop-loss limits. The workers' compensation program for the policy year ended January 31, 2003 had a specific stop loss amount of $250,000 with no aggregate stop loss limit. The general liability program provided for a specific stop loss of $35,000 per claim with no aggregate stop loss limit. It is our policy to record our self-insurance reserves, as determined actuarially, based upon claims filed and an estimate of claims incurred but not reported. Based on the actuarial methods used, we estimate our ultimate aggregate loss for workers' compensation and general liability in the amount of $3.4 million and $500,000, respectively. These amounts are subject to adjustment based on actual costs being greater or less than expected. F-10 Revenue Recognition Retail merchandise sales are recognized at the point of sale. We defer the recognition of layaway sales and the related cost of sales until the time the merchandise is fully paid by the customer. Deferred revenue is included in the accounts payable in the accompanying balance sheets. Costs of Sales Costs of sales include merchandise cost, transportation cost, markdowns, shrink, direct distribution and processing costs, and inventory capitalization cost. Advertising Costs Advertising costs are expensed as incurred. Advertising costs for the fiscal years ended February 1, 2003, February 2, 2002 and February 3, 2001 were approximately $24.7 million, $20.9 million and $17.7 million, respectively. Deferred Rent Rent expense under non-cancelable operating lease agreements is recorded on a straight-line basis over the life of the respective leases. The excess rent expense over rent paid is accounted for as deferred rent. Store Pre-opening and Closing Costs Store pre-opening costs (costs of opening new stores, including grand opening promotions, training and store set-up costs) are expensed as incurred. Costs associated with closing stores, consisting primarily of inventory liquidation costs, non-recoverable investment in fixed assets and any future lease obligations, are recognized as operating expense at the date of a commitment to an exit or disposal plan. Closing costs related to exit or disposal activities initiated after December 31, 2002 will be expensed as incurred. Debt Issuance Costs Debt issuance costs are amortized to interest expense evenly over the life of the related debt. For fiscal year ended February 1, 2003, February 2, 2002 and February 3, 2001, amortization for debt issuance costs was $118,000, $132,000 and $84,000, respectively. Income Taxes Income taxes are accounted for under the asset and liability method required by SFAS No. 109, "Accounting for Income Taxes." Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Stock-based Compensation We have elected under the provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" to continue using the intrinsic value method of accounting for employee stock- based compensation in accordance with Accounting Principles Board No. 25 ("APB No. 25"), "Accounting for Stock Issued to Employees." Under the intrinsic value method, compensation expense is recognized only in the event that the exercise F-11 price of options granted is less than the market price of the underlying stock on the date of grant. The fair value method generally requires entities to recognize compensation expense over the vesting period of options based on the estimated fair value of the options granted. We have disclosed the pro forma effect of using the fair value based method to account for our stock-based compensation as required by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." The following table illustrates the effect on net income (loss) and net income (loss) per common share if we had applied the fair value recognition provisions of SFAS No. 148. (in thousands) -------------- 2002 2001 2000 ---- ---- ---- Net income (loss) before stock-based compensation, as reported $ (28,509) $ (10,896) $ 21,264 Stock based compensation using the fair value method, net of tax (3,159) (5,877) (2,505) ---------- ---------- ---------- Pro-forma net income (loss) available to common shareholders $ (31,668) $ (16,773) $ 18,759 ========== ========== ========== Pro-forma basic income (loss) per common share $ (2.44) $ (1.31) $ 1.49 Pro-forma diluted income (loss) per common share $ (2.44) $ (1.31) $ 1.44
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models also require the input of highly subjective assumptions such as expected option life and expected stock price volatility. Because our employee stock-based compensation plan has characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, we believe that the existing option valuation models do not necessarily provide a reliable single measure of the fair value of awards from those plans. The weighted-average fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model using the following weighted-average assumptions: (i) expected dividend yield of 0.00%, (ii) expected volatility of 104.0%, 96.86% and 98.75% for fiscal 2002, 2001 and 2000, respectively, (iii) expected life of eight years for fiscal 2002, nine years for fiscal 2001 and seven years for fiscal 2000, and (iv) risk-free interest rate of 3.55%, 5.71% and 5.01% for fiscal 2002, 2001 and 2000, respectively. Income (Loss) per Share We compute income (loss) per share in accordance with SFAS No. 128, "Earnings Per Share." Under the provisions of SFAS No. 128, basic earnings (loss) per share is computed based on the weighted average shares outstanding. Diluted income (loss) per share is computed based on the weighted average shares outstanding and potentially dilutive common stock equivalent shares. Approximately 127,242 shares of common stock equivalent shares are not included in the computation of diluted loss per share for fiscal 2002 because the effect would have been anti-dilutive. F-12 Weighted average number of common shares outstanding for each fiscal year are determined as follows: (in thousands) -------------- 2002 2001 2000 ---- ---- ---- Weighted average number of common shares outstanding 12,957 12,807 12,589 Effect of dilutive securities: Warrants that are common stock equivalents - - 33 Options that are common stock equivalents - - 444 ------ ------ ------ Adjusted weighted average number of common shares outstanding for diluted computations 12,957 12,807 13,066 ------ ------ ------
Use of Estimates Our management has made a number of estimates and assumptions relating to the reporting of assets and liabilities and 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 to prepare these financial statements in conformity with generally accepted accounting principles in the United States. Actual results could differ from those estimates. Reclassifications Certain prior period amounts have been reclassified to conform their presentation to the fiscal 2002 financial statements. Recent Accounting Pronouncements In April 2002, the FASB issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections", which rescinds SFAS No. 4, "Reporting Gains and Losses from Extinguishment of Debt" and an amendment of that Statement, and SFAS No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements." SFAS No. 145 also rescinds SFAS No. 44, "Accounting for Intangible Assets of Motor Carriers." SFAS No. 145 amends SFAS No. 13, "Accounting for Leases", to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. SFAS No. 145 is effective for fiscal years beginning after May 15, 2002. We do not expect the adoption of this statement will have a material impact on our financial position or results of operations. In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", which addresses significant issues regarding the recognition, measurement, and reporting of costs associated with exit and disposal activities, including restructuring activities. This statement requires that costs associated with exit or disposal activities be recognized when they are incurred rather than at the date of a commitment to an exit or disposal plan. SFAS No. 146 is effective for all exit or disposal activities initiated after December 31, 2002. We do not expect the adoption of this statement will have a material impact on our financial position or results of operations. In November 2002, the FASB issued Interpretation No. ("FIN") 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others", which requires elaborating on the disclosures that must be made by a guarantor in financial statements about its obligations under certain guarantees. It also requires that a guarantor recognize, at the inception of certain types of guarantees, a liability for the fair F-13 value of the obligation undertaken in issuing the guarantee. The disclosure requirements of FIN 45 are effective for financial statements issued after December 15, 2002, and have been applied in the presentation of the accompanying consolidated financial statements. The recognition requirements of FIN 45 are applicable for guarantees issued or modified after December 31, 2002. We have not yet determined the effect, if any; the recognition requirement for guarantees issued or modified after December 31, 2002 will have on our business, results of operations and financial condition. In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure." This statement amends SFAS No. 123, "Accounting for Stock-Based Compensation" to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. Certain of the disclosure modification are required for fiscal years ending after December 15, 2002. We have not yet completed the final evaluation of the transitioning options presented by SFAS No. 148. However, during fiscal 2003, we expect to reach a determination of whether and, if so, when to change our existing accounting for stock-based compensation to the fair value method in accordance with the transition alternatives of SFAS No. 148. In January 2003, the FASB issued FIN 46 - "Consolidation of Variable Interest Entities." FIN 46 clarifies the application of Accounting Research Bulletin No. 51 - Consolidated Financial Statements to those entities defined as "Variable Interest Entities" (more commonly referred to as special purpose entities) in which equity investors do not have the characteristics of a "controlling financial interest" or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 applies immediately to all Variable Interest Entities created after January 31, 2003, and by the beginning of the first interim or annual reporting period commencing after June 15, 2003 for Variable Interest Entities created prior to February 1, 2003. 2. FISCAL 2002 RESTRUCTURING CHARGE In December 2002, we recorded a restructuring charge of $14.4 million in conjunction with the decision to close 23 stores as well as to consolidate both our distribution center network and corporate overhead structure. The purpose of these restructuring initiatives was to improve store profitability, reduce costs and improve efficiency. The charge and the related liability are recognized in accordance with the Emerging Issues Task Force ("EITF") No. 94-3 "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." EITF No. 94-3 provides specific requirements as to the appropriate recognition of costs associated with employee termination and other exit costs. Employee termination costs are recognized when, prior to the date of the financial statements, management having the appropriate level of authority to involuntarily terminate employees approves and commits us to the plan of termination and establishes the benefits that current employees will receive upon termination and the benefit is communicated to employees. Other exit costs are costs resulting from an exit plan that are not associated with or that do not benefit activities that will be continued. The components of the restructuring charge are computed based on our estimate of the realizable value of the affected tangible assets, including non-cash fixed asset write-downs and inventory liquidation costs and estimated exit costs, including lease termination or sublease costs, employee severance based on existing severance policies and local laws and tear-down costs. The restructuring charge is described in more detail in the following table. F-14 (in thousands) -------------- Lease termination costs $ 6,513 Inventory liquidation costs (non-cash)* 1,082 Fixed asset write-downs (non-cash)** 4,969 Employee termination costs 1,027 Other cash costs 807 -------------- $ 14,398 -------------- * A non-cash inventory liquidation cost of $1.1 million is recorded as a component of cost of sales. ** Non-cash fixed asset write-downs of $5.0 million is recorded as a valuation allowance for leasehold improvements and equipment. As of February 1, 2003, we had closed 13 of the 23 identified stores. Subsequent to February 1, 2003, we closed two additional stores; and we, to date, had terminated the lease obligations of 11 of these closed stores.
The balance of liability related to the fiscal 2002 restructuring charge at February 1, 2003 was as follows: (in thousands) ------------- Balance at Restructuring Cash Non-cash February 1, Charge Payments Charges 2003 ------------- -------- -------- ----------- Lease termination costs $ 6,513 $ - $ 35 $ 6,548 Inventory liquidation costs (non-cash) 1,082 - (565) 517 Fixed asset write-downs (non-cash) 4,969 - (1,317) 3,652 Employee termination costs 1,027 (119) - 908 Other cash costs 807 (21) - 786 ------------- -------- -------- ----------- $ 14,398 $ (140) $(1,847) $ 12,411 ------------- -------- -------- -----------
3. FISCAL 2001 RESTRUCTURING CHARGE In January 2002, we recorded a restructuring charge of $21.2 million in conjunction with the decision to close 28 under-performing stores as well as the realignment of our field organization and workforce reductions. The purpose of these restructuring initiatives was to improve store profitability, streamline field operations, reduce costs and improve efficiency. The components of the restructuring charge are computed based on our estimate of the realizable value of the affected tangible assets, including non-cash fixed asset write-downs and inventory liquidation costs and estimated exit costs, including lease termination or sublease costs, employee severance based on existing severance policies and local laws and tear-down costs. The restructuring charge is described in more detail in the following table. (in thousands) -------------- Lease termination costs $ 13,724 Inventory liquidation costs (non-cash)* 2,870 Fixed asset write-downs (non-cash)** 2,052 Employee termination costs 1,206 Other cash costs 1,379 -------------- $ 21,231 -------------- * A non-cash inventory liquidation cost of $2.9 million is recorded as a component of cost of sales. ** Non-cash fixed asset write-downs of $2.1 million is recorded as a valuation allowance for leasehold improvements and equipment.
F-15 We closed 24 of these 28 stores during the first quarter of fiscal 2002 and the remaining four stores in January 2003. To date, we had terminated the lease obligations of 21 of these stores. In light of the favorable experience related to the costs of closing these stores, we recorded a non-cash adjustment to reduce the reserve for the fiscal 2001 restructuring initiatives by approximately $5.0 million during the fourth quarter of fiscal 2002. The adjustment included (1) reduction of reserve for lease termination costs by $3.8 million, (2) reduction of reserve for inventory liquidation costs by $1.3 million, and (3) an additional reserve for fixed asset write-downs of $94,000. The balance of liability related to the fiscal 2001 restructuring charge at February 1, 2003 was as follows: (in thousands) ------------- Balance at Restructuring Cash Non-cash February 1, Charge Payments Charges 2003 ------------- -------- -------- ----------- Lease termination costs $ 13,724 $(5,953) $ (3,496) $ 4,275 Inventory liquidation costs (non-cash) 2,870 - (2,851) 19 Fixed asset write-downs (non-cash) 2,052 - (1,919) 133 Employee termination costs 1,206 (1,136) - 70 Other cash costs 1,379 (1,102) - 277 ------------- -------- -------- ----------- $ 21,231 $(8,191) $ (8,266) $ 4,774 ------------- -------- -------- -----------
4. NOTE RECEIVABLE In July 2002, we entered into a temporary bridge financing agreement (the "Agreement") with one of our trade vendors (the "Borrower") in which we, subject to the terms and conditions of the Agreement, would provide a $4.0 million revolving line of credit facility to the Borrower. Advances made to the Borrower under this Agreement are secured by the Borrower's accounts receivable, inventory, personal property and other assets including cash. Borrowings under this facility are also secured by personal guarantees from the principals of the Borrower. This Agreement expired on October 11, 2002, and we have not made any direct advances to the Borrower thereafter. As of February 1, 2003, the outstanding borrowings plus accrued interest under this Agreement were approximately $1.1 million, which was fully reserved. F-16 5. LEASEHOLD IMPROVEMENTS AND EQUIPMENT Leasehold improvements and equipment consist of the following: (in thousands) -------------- February 1, February 2, 2003 2002 ----------- ----------- Furniture, fixtures and equipment $ 59,455 $ 57,971 Leasehold improvements 14,263 13,683 Automobiles 890 823 Equipment under capital leases 2,549 3,153 ----------- ----------- 77,157 75,630 Less: accumulated depreciation, amortization and valuation allowance (48,555) (38,588) ----------- ----------- $ 28,602 $ 37,042 ----------- -----------
6. GOODWILL As required, we adopted SFAS No. 142 on February 3, 2002 and ceased the amortization of goodwill accordingly. The following table presents the reconciliation of net income and per share data to what would have been reported had the new rules been in effect during the fiscal years ended February 1, 2003, February 2, 2002 and February 3, 2001 (in thousands, except per share data): 2002 2001 2000 ---- ---- ---- Reported net income (loss) $ (28,509) $ (10,896) $ 21,264 Add back goodwill amortization, net of tax - 984 1,124 ---------- ---------- -------- Adjusted net income (loss) $ (28,509) $ (9,912) $ 22,388 ---------- ---------- -------- Basic net income (loss) per common share Reported net income (loss) $ (2.20) $ (0.85) $ 1.69 Goodwill amortization, net of tax - 0.08 0.09 ---------- ---------- --------- Adjusted net income (loss) $ (2.20) $ (0.77) $ 1.78 ---------- ---------- ---------
7. ACCRUED EXPENSES Accrued expenses consist of the following: (in thousands) -------------- February 1, February 2, 2003 2002 ----------- ----------- Accrued compensation and related costs $ 4,070 $ 4,554 Accrued restructuring charges 11,117 12,653 Accrued workers compensation 4,741 2,341 Other accrued expenses 7,903 8,370 ----------- ----------- $ 27,831 $ 27,918 ----------- -----------
F-17 8. LONG-TERM DEBT AND REVOLVING CREDIT FACILITY Long-term debt and revolving credit facility consist of the following: (in thousands) -------------- February 1, February 2, 2003 2002 ----------- ----------- Junior subordinated notes, non-interest bearing, $ 9,445 $ 10,376 discounted at a rate of 10%, principal payments in annual installments of $3.0 million and final balloon payment of $5.3 million due May 2005 Less current maturities (3,000) (2,000) ----------- ----------- Long-term debt, net of current maturities $ 6,445 $ 8,376 ----------- ----------- Revolving credit facility $ 6,300 $ -
Revolving Credit Facility We have a $50.0 million revolving credit facility with a financial institution. Under this revolving credit facility, we may borrow up to 70% of our eligible inventory and 85% of our eligible accounts receivable, as defined, up to $50.0 million. The credit facility also included a $15.0 million sub-facility for letters of credit. In September 2002, we extended the term of this revolving credit facility until March 2006. As of February 1, 2003, interest on the credit facility was at the prime rate plus 0.50%, or at our election, LIBOR plus 2.50%. Under the terms of the credit facility, the interest rate may increase or decrease subject to earnings before interest, tax obligations, depreciation and amortization expense (EBITDA), as defined, on a rolling four fiscal quarter basis. Accordingly, prime rate borrowings could range from prime to prime plus 1.00% and LIBOR borrowings from LIBOR plus 1.50% to LIBOR plus 3.00%. The revolving credit facility provides for a $7.5 million availability block against our availability calculation as defined. We are obligated to pay fees equal to 0.125% per annum on the unused amount of the credit facility. The credit facility is secured by a first lien on accounts receivable and inventory. At February 1, 2003, we were in compliance with all financial covenants, as defined, and had outstanding borrowings of $6.3 million and letters of credit of $5.1 million under our revolving credit facility. At February 1, 2003, based on eligible inventory and accounts receivable, we were eligible to borrow $32.5 million under our revolving credit facility and had $13.6 million available after giving effect for the $7.5 million availability block, as defined. Junior Subordinated Notes The Junior Subordinated Notes are non-interest bearing and are reflected on our balance sheets at the present value using a discount rate of 10%. As of February 1, 2003, the Junior Subordinated Notes had a face value of $11.3 million and a related unamortized discount of $1.9 million, resulting in a net carrying value of $9.4 million. The discount is amortized to interest expense as a non-cash charge until the notes are paid in full. We made a principal payment on the Junior Subordinated Notes of $2.0 million in December 2002. Additional principal payments are scheduled on December 31, 2003 ($3.0 million) and December 31, 2004 ($3.0 million) and a final payment on May 28, 2005 ($5.3 million). F-18 9. INCOME TAXES Significant components of income taxes (benefit) are as follows: (in thousands) -------------- 2002 2001 2000 ---- ---- ---- Federal income taxes (benefit) Current $ (8,200) $ (3,069) $ 11,249 Deferred (8,321) (2,754) (3,596) ---------- ---------- ---------- (16,521) (5,823) 7,653 ---------- ---------- ---------- State income taxes (benefit) Current (204) (541) 2,088 Deferred (1,427) (486) (683) ---------- ---------- ---------- (1,631) (1,027) 1,405 ---------- ---------- ---------- $(18,152) $ (6,850) $ 9,058 ---------- ---------- ----------
We have received the federal tax refund of $8.2 million in March 2003. The principal temporary differences that give rise to significant portions of the deferred tax assets and liabilities are presented below: (in thousands) -------------- February 1, February 2, 2003 2002 ----------- ----------- Deferred tax assets Net operating loss carryforwards $ 10,483 $ 7,644 Compensated absences and bonuses 3,002 2,719 Deferred rent 1,325 1,807 Closed store accrual 101 299 Excess of tax over book inventory 3,648 1,649 Accrued expenses 12,255 7,552 Fixed assets 490 313 Other 1,174 748 ------------ ----------- Total gross deferred tax assets 32,478 22,731 Less: valuation allowance (7,647) (7,647) ------------ ----------- Net deferred tax assets 24,831 15,084 ------------ ----------- Deferred tax liabilities Tax basis difference 4,349 4,349 ------------ ----------- Deferred tax liabilities 4,349 4,349 ------------ ----------- Net deferred tax asset $ 20,482 $ 10,735 ------------ -----------
We have established a valuation allowance because we are uncertain when we may realize the benefits of our deferred tax assets and annual limitations on the usage of net operating loss carryforwards. F-19 The difference between the expected income taxes (benefit) computed by applying the U.S. federal income tax rate of 35% to net income (loss) from continuing operations for each of the fiscal years 2002, 2001 and 2000, and actual taxes (benefit) is a result of the following: (in thousands) -------------- 2002 2001 2000 ---- ---- ---- Computed "expected" taxes (benefit) $(16,331) $ (6,211) $10,612 Amortization of goodwill - 656 656 Change in valuation allowance - - (3,064) Business credits (195) (238) (86) State income taxes, net of federal income tax credit (1,586) (1,064) 1,819 Refund of taxes - - (900) Other, net (40) 7 21 --------- --------- -------- $(18,152) $ (6,850) $ 9,058 --------- -------- --------
At February 1, 2003, we had net operating loss carryforwards for federal income tax purposes of approximately $26.2 million that expire starting in fiscal 2012. A portion of these losses is limited under Section 382 of the Internal Revenue Code due to prior ownership changes. 10. LEASE COMMITMENTS We operate retail stores, distribution centers and administrative offices under various operating leases. Total rent expense was approximately $42.5 million, $40.7 million and $29.9 million, including contingent rent expense of approximately $98,000, $228,000 and $435,000, for fiscal years ended February 1, 2003, February 2, 2002 and February 3, 2001, respectively. Rent expense is recorded on a straight-line basis over the life of the lease. For fiscal 2002, cash payment requirements exceeded rent expense by approximately $414,000. For fiscal 2001 and 2000, rent expense charged to operations exceeded cash payment requirements by approximately $264,000 and $1.1 million, respectively, and resulted in an increase to the deferred rent liability for the same amount. We were obligated under various capital leases for equipment that expired at various dates during fiscal 2003. Equipment and related accumulated depreciation recorded under capital leases are as follows: (in thousands) -------------- February 1, February 2, 2003 2002 ----------- ----------- Equipment $ - $ 584 Less: accumulated depreciation - (575) ----------- ----------- $ - $ 9 ----------- -----------
F-20 At February 1, 2003, the future minimum lease payments under operating leases with remaining non-cancelable terms are as follows: (in thousands) -------------- Fiscal year: 2003 $ 29,903 2004 27,626 2005 24,264 2006 18,111 2007 13,076 Thereafter 44,422 -------------- Total minimum lease payments $ 157,402 --------------
11. STOCKHOLDERS' EQUITY We have 35,000,000 shares of common stock authorized for issuance at a par value of $0.01 per share. At February 1, 2003, we have reserved 1,367,346 shares of common stock for issuance in connection with our stock option plan and 450,000 shares of common stock for issuance related to stock options issued outside our stock option plan. We have also reserved 299,643 shares for issuance under the employee stock purchase plan and 82,690 shares for issuance related to outstanding warrants. We have never paid cash dividends on our common stock and do not anticipate paying cash dividends in the foreseeable future. Currently, we are contractually prohibited from paying cash dividends on the common stock under the terms of our existing revolving credit facility and junior subordinated notes without the consent of the lenders. As of February 1, 2003, the outstanding stock subscription notes receivable balance was $1.1 million, net of a valuation allowance. All outstanding stock subscription notes receivable are either due from current or former members of management with a five-year term with maturity dates from April 29, 2003 to July 29, 2003 and an interest rate of 8.0% per annum. At February 1, 2003, based on the current stock price compared to the principal notes receivable balance plus accrued interest, we incurred a non-cash charge of approximately $1.0 million to reflect the fair value of these stock subscription notes receivable. The valuation allowance relates to three notes with a maturity date of April 29, 2003 and due from two former members of management in the original principal amount of $1.4 million, $250,000 and $250,000 respectively, with certain limitations on their personal liability to repay these notes. The first note, due from Michael M. Searles, our former President and Chief Executive Officer, in the principal amount of $1.4 million is secured by 242,662 shares of our common stock, and he has personal liability to repay up to $600,000, including accrued interest. The second note, due from Jonathan W. Spatz, our former Chief Financial Officer, in the principal amount of $250,000 is secured by 32,932 shares of our common stock, and he has personal liability to repay up to $107,000, including accrued interest. The third note, also due from Mr. Spatz, in the principal amount of $250,000 is secured by 43,332 shares of our common stock, and he has personal liability for the entire principal balance plus accrued interest. The remaining outstanding stock subscription notes receivable are believed to be fully collectible with recourse. In fiscal 2002, we issued a total of 450,000 restricted shares of common stock to certain of our new senior management members as inducement to accept employment at the time they were hired. These restricted shares shall vest in installments; 150,000 shares at such time as the closing market price of our common stock equals or exceeds $10.00 per share for 20 consecutive trading days in any three-month period, 150,000 shares at such time as the closing market price of our F-21 common stock equals or exceeds $20.00 per share for 20 consecutive trading days in any three-month period, and the final 150,000 shares at such time as the closing market price of our common stock equals or exceeds $30.00 per share for 20 consecutive trading days in any three-month period. In the event that the closing market price of our common stock equals or exceeds $10.00, $20.00 and $30.00 per share for 20 consecutive trading days in any three-month period, at a minimum we may incur non-cash charges of approximately $1.5 million, $3.0 million, and $4.5 million, respectively. 12. STOCK OPTIONS AND WARRANTS At February 1, 2003, warrants to purchase 82,690 common shares were outstanding. These warrants have an exercise price of $19.91 and expire in May 2005. We have a stock option plan, the Amended and Restated Factory 2-U Stores, Inc. 1997 Stock Option Plan (the "Plan"). Options may be granted as incentive or nonqualified stock options. We may grant up to 2,157,980 options under this Plan. The options are issued at fair market value with exercise prices equal to our stock price on the date of grant. Options vest over three to five years; are exercisable in whole or in installments; and expire from five to ten years from the date of grant. Our Board of Directors has granted stock options to members of the Board and to our management. A summary of our stock option activity and related information is as follows: Number of Weighted average options exercise price --------- ---------------- Balance at January 29, 2000 1,380,438 $ 10.53 Granted 335,584 28.35 Exercised (341,932) 7.60 Canceled (88,658) 16.85 ---------- ---------------- Balance at February 3, 2001 1,285,432 15.52 Granted 238,323 20.64 Exercised (66,456) 7.90 Canceled (41,141) 24.38 ---------- ---------------- Balance at February 2, 2002 1,416,158 16.49 Granted 807,556* 5.34 Exercised (124,764) 7.36 Canceled (375,546) 20.09 ---------- ---------------- Balance at February 1, 2003 1,723,404 $ 11.14 Exercisable at February 1, 2003 734,196 $ 12.13
F-22 The following table summarizes information about the stock options outstanding at February 1, 2003: Weighted- average Weighted- Weighted- Number of contractual average Number of average Range of options life exercise options exercise exercise prices outstanding (Years) price exercisable price - --------------- ----------- ----------- -------- ----------- ---------- $0.00 - $4.23 612,366* 7.3 $ 2.38 115,625 $ 2.14 $4.23 - $8.45 343,160 2.6 $ 6.75 320,560 $ 6.75 $8.45 - $12.68 92,243 6.0 $ 12.06 52,111 $ 12.05 $12.68 - $16.90 277,670 8.5 $ 14.88 47,798 $ 15.13 $16.90 - $21.13 76,410 6.8 $ 20.19 27,202 $ 19.69 $21.13 - $25.35 148,825 7.1 $ 24.21 64,878 $ 24.13 $25.35 - $29.58 130,287 5.9 $ 26.81 83,045 $ 26.46 $29.58 - $33.80 10,193 7.7 $ 31.89 5,277 $ 31.83 $33.80 - $38.03 25,750 6.9 $ 36.94 13,000 $ 37.06 $38.03 - $42.25 6,500 4.8 $ 40.22 4,700 $ 40.92 ----------- ----------- -------- ----------- --------- 1,723,404 6.3 $ 11.14 734,196 $ 12.13 ----------- ----------- * Including 450,000 stock options granted to certain of our new senior management members as an inducement to accept employment at the time when they were hired, subject to shareholder approval of an appropriate amendment to the Plan. In the event that such an amendment is not approved, we are nevertheless contractually obligated with respect to such options which will not be granted under the Plan.
In fiscal 2000, we recorded non-cash stock-based compensation expense of $4.8 million when 92,961 stock options with a market price hurdle of $24.89 became exercisable in July 2000 and 71,419 stock options with a market price hurdle of $33.19 became exercisable in August 2000. In fiscal 2001, we recorded non-cash stock-based compensation expense of $456,000 as a result of the removal of the market price hurdle of 19,361 stock options held by former Executive Vice President who retired in August 2001. In fiscal 2002, there was no event related to our stock options triggered by the market price hurdle; and therefore, we did not record any non-cash stock-based compensation expense. 13. EMPLOYEE BENEFITS We sponsor a defined contribution plan, qualified under Internal Revenue Code Section 401(k), for the benefit of employees who have completed twelve months of service and who work a minimum of 1,000 hours during that twelve-month period. We make a matching contribution equal to 20% of participating employees' voluntary contributions. Participants may contribute from 1% to 15% of their compensation annually, subject to IRS limitations. We contributed approximately $238,000, $232,000 and $208,000 in fiscal 2002, 2001 and 2000, respectively. We also sponsor the Factory 2-U Stores, Inc. Employee Stock Purchase Plan which allows eligible employees to acquire shares of our Common Stock at a discount from market price, at periodic intervals, paid for with accumulated payroll deductions. The discount is 15% of the lower of the market price per share as quoted on the NASDAQ National Market on the first and last day of an offering period. The Plan will terminate when all 350,000 shares available for issuance under the Plan are sold although the Plan may be terminated earlier by us at any time. As of February 1, 2003, eligible employees had purchased 50,357 shares of our Common Stock under the Plan. F-23 14. LEGAL MATTERS, COMMITMENTS AND CONTINGENCIES On December 15, 2000, Pamela Jean O'Hara ("O'Hara"), a former employee in our Alameda, California store, filed a lawsuit against us entitled "Pamela Jean O'Hara, Plaintiff, vs. Factory 2-U Stores, Inc., et al., Defendants", Case No. 834123-5, in the Superior Court of the State of California for the County of Alameda (the "O'Hara Lawsuit"). On August 2, 2001, O'Hara and four other former employees in our Alameda store, filed a Second Amended Complaint in the O'Hara Lawsuit. The Second Amended Complaint in the O'Hara Lawsuit alleges that we violated the California Labor Code and Industrial Wage Commission Orders, as well as the California Unfair Competition Act, by failing to pay overtime to the plaintiffs. Plaintiffs purport to bring this action on behalf of themselves and all other store managers, assistant store managers and other undescribed "similarly-situated employees" in our California stores from December 15, 1996 to present. The Second Amended Complaint sought compensatory damages, interest, penalties, attorneys' fees, and disgorged profits, all in unspecified amounts. The Second Amended Complaint also sought injunctive relief requiring payment of overtime to "non-exempt" employees. On September 4, 2001, we filed an answer in which we denied the material allegations of the Second Amended Complaint. Pursuant to an Order dated December 3, 2001, the Court in the O'Hara Lawsuit granted Plaintiff's motion for certification of two plaintiff classes: (1) all persons who have been employed as assistant store managers at one of our California stores at any time after December 15, 1996, and who worked hours which would have entitled them to overtime had they not been exempt employees; and (2) all persons who have been employed as store managers at one of our California stores at any time after December 15, 1995, and who worked hours which would have entitled them to overtime had they not been exempt employees. We made a settlement offer to each member of the two plaintiffs classes, pursuant to which we offered to pay $1,000 for each year of service (or a pro rata portion of each partial year) after December 15, 1996 and between February 1, 2002 in exchange for a release of all overtime claims. Approximately 263 members of the plaintiff classes accepted the settlement offer. In August 2002 we reached a tentative settlement of the O'Hara Lawsuit. On November 7, 2002, the Court entered an order granting final approval of the settlement agreement. Pursuant to the settlement agreement, we have agreed to pay the plaintiff class members (and their attorneys) a total of $2,000,000 in settlement of all their claims. The settlement became effective as of April 25, 2003. In conjunction with the settlement of this O'Hara litigation, we recorded a charge of approximately $2.1 million in fiscal 2002, and we have paid approximately $869,000 as of February 1, 2003. We are subject to pending and threatened legal actions that arise in the normal course of business. In the opinion of our management, based in part on the advice of legal counsel, the ultimate disposition of these current matters will not have a material adverse effect on our financial position or results of operations. We have entered into an employment contracts with three of our officers, which defines their duties and compensation and which could provide severance in the event of their termination of employment. F-24 15. RELATED PARTY TRANSACTIONS In March 1997, we entered into an agreement with Three Cities Research, Inc. ("TCR") engaging TCR to act as financial advisor to us. Under this agreement, we pay TCR an annual fee of $50,000 and reimburse TCR for all of its out-of-pocket expenses incurred for services rendered, up to an aggregate of $50,000 annually. We reimbursed TCR for out-of-pocket expenses in the approximate amounts of $47,000, $34,000 and $37,000 during fiscal 2002, 2001 and 2000, respectively. As of February 1, 2003, TCR controlled approximately 22.8% of our outstanding common stock and a principal of TCR is a member of our Board of Directors. On November 4, 2002, with the approval of the Board of Directors, we appointed Ronald Rashkow to a newly-created position as the Lead Director to our Board for three years. In connection with his Lead Director duties, we granted 50,000 options at an exercise price of $1.68 per share, the fair market value of our common stock on the date of grant. These options are fully vested and are exercisable for five years from the date of grant. We also issued 25,000 shares of restricted common shares to Mr. Rashkow at a price of $0.01 per share, subject to his completion of 12 months of service. In addition to this equity compensation, we are also required to pay monthly fee of $12,500 plus reimbursement of all reasonable out-of-pocket expenses. 16. SUBSEQUENT EVENTS (UNAUDITED) Subsequent to February 1, 2003, the following events occurred: Revolving Credit Facility On February 14, 2003, we obtained the approval from the lender to expand the scope of the collateral securing the obligations under our revolving credit facility and increased the sub-facility for letters of credit to $15.0 million. In addition, we obtained the lender's consent to the incurrence by us of up to $10.0 million in additional indebtedness, which may be secured by a junior lien on the collateral. On April 10, 2003, we amended the terms of our revolving credit facility to add $7.5 million of term loans, to add one financial covenant, and to amend certain reporting provisions and other terms. The term loans consist of a $6.5 million junior term note secured primarily by inventory and accounts receivable and a $1.0 million term note secured primarily by equipment and other assets. These notes bear interest at the rate of 14.50% per annum on the then current outstanding balance, and mature on April 10, 2004. The $6.5 million junior term note can be extended for one additional year. The financial covenant, which is related to achieving a minimum earnings before interest, tax obligations, depreciation and amortization expense (EBITDA), as defined, is subject to testing only if the Triggering Availability, as defined, is less than $10.0 million on the last three days of each month commencing on May 3, 2003. This financial covenant will terminate at such time that the $7.5 million term loans are no longer outstanding. At April 25, 2003, we were in compliance with all financial covenants, as defined, and had outstanding borrowings of $7.4 million and letters of credit of $12.3 million under our revolving credit facility. In addition, based on eligible inventory and accounts receivable, we were eligible to borrow $45.0 million under our revolving credit facility and had $17.8 million available for future borrowings after giving effect for the $7.5 million availability block, as defined. F-25 Stockholders' Equity On March 6, 2003, we completed a private offering of 2,532,679 shares of our common stock for aggregate proceeds of approximately $5.7 million, net of placement fees. The placement agent also received warrants to purchase 75,000 shares of our common stock at an exercise price of $3.50 per share. These warrants will expire in March 2006. On March 21, 2003, two stock subscription notes in the principal amount of $99,548 and $50,000, respectively, plus accrued interest, were paid in full by current members of management. On April 29, 2003, certain shareholder notes matured and we foreclosed on the collateral as of the close of business. The principal and accrued interest due on Mr. Searles' note was $1,458,608 and the collateral had a market value on April 29, 2003 of $1,198,750, resulting in a deficiency of $259,858, for which he is not personally liable for the deficiency under the terms of the note. In addition, the principal and accrued interest on Mr. Spatz's notes were $688,197 and the collateral had a market value on April 29, 2003 of $376,744, resulting in a deficiency of $311,453, for which he is personally liable for $136,614 of the deficiency under the terms of his notes. Additionally, on April 29, 2003, the principal and accrued interest due on the notes for Tracy W. Parks, our former Executive Vice President and Chief Operating Officer, was $117,042 and the collateral had a market value of $82,197, resulting in a deficiency of $34,845, for which he is personally liable under the terms of his notes. Related Party Transactions On March 6, 2003, two individual investment entities controlled by TCR, Three Cities Offshore II, C.V. and Three Cities Fund II, L.P., participated in our private offering transaction and acquired 407,207 shares and 240,793 shares of our common stock, respectively, at a purchase price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $1,782,000. Including these additional shares acquisition, TCR currently owns approximately 23.3% of our outstanding common stock. Mr. Rashkow, our Lead Director, also participated in this private offering transaction and acquired 72,700 shares of our common stock at a price of $2.75 per share (a price in excess of the closing market price of our common stock on such date), for an aggregate purchase price of $199,925. Including these 72,700 shares, Mr. Rashkow's total current direct and indirect ownership of our outstanding common stock is approximately 1.6%. Settlement Agreement On March 19, 2003, we entered into a settlement agreement with a former candidate for an executive level position who alleged that we breached an oral agreement to employ him for one year. Under the terms of the settlement agreement, we are obligated to pay $390,000 payable in 52 equal bi-weekly installments. Legal Matters On or about April 28, 2003, Lynda Bray and Masis Manougian, two of our current employees, filed a lawsuit against us entitled "Lynda Bray, Masis Manougian, etc., Plaintiffs, vs. Factory 2-U Stores, Inc., etc., Defendants", Case No. RCV071918 in the Superior Court of the State of San Bernardino (the "Bray Lawsuit"). The complaint in the Bray Lawsuit alleges that we violated the settlement agreement in the O'Hara Lawsuit, the California Labor Code, Industrial Wage Commission Orders and the California Unfair Competition Act by failing to pay wages and overtime for all hours worked, by failing to document all hours worked, by threatening to retaliate against employees who sought to participate in the settlement of the O'Hara Lawsuit and by failing to inform prospective employees of unpaid wage claims. Plaintiffs purport to bring this action on behalf of all persons who were employed in one of our California stores at any F-26 time after December 15, 1996. Plaintiffs seek compensatory and exemplary damages, interest, penalties, attorneys' fees and disgorged profits in an amount which plaintiffs estimated to be not less than $100,000,000. Plaintiffs also seek injunctive relief requiring correction of the alleged unlawful practices. We believe that the material allegations of the complaint in the Bray Lawsuit are false and that each of the claims asserted in the Bray Lawsuit is meritless. We also believe that the settlement in the O'Hara Lawsuit bars some of the claims asserted in the Bray Lawsuit. We intend to vigorously defend against the Bray Lawsuit. 17. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The results of operations for fiscal 2002 and 2001 were as follows: (in thousands, except per share data) ------------------------------------- First Second Third Fourth Quarter Quarter Quarter Quarter ------- -------- ------- ------- Fiscal 2002 ----------- Net sales $116,951 $128,088 $134,506 $155,725 Gross profit 41,158 41,029 44,652 35,546 Operating income (4,977) (9,418) (4,771) (25,884) Net loss (3,141) (5,837) (3,516) (16,015) Loss per share Basic $ (0.24) $ (0.45) $ (0.27) $ (1.23) Diluted (0.24) (0.45) (0.27) (1.23) Fiscal 2001 ----------- Net sales $125,824 $139,254 $145,568 $169,814 Gross profit 41,759 49,820 50,260 53,231 Operating income (loss) (2,165) 113 (216) (14,518) Net loss (1,448) (195) (324) (8,929) Loss per share Basic $ (0.11) $ (0.02) $ (0.03) $ (0.70) Diluted (0.11) (0.02) (0.03) (0.70)
As a result of rounding differences, total amounts disclosed in the Statements of Operations may not agree to the sum of the amounts disclosed above for the four quarters. F-27 EX-10 3 exh5thamend.txt 5TH AMENDMENT TO THE CIT FINANCING AGREEMENT Exhibit 10.10 FIFTH AMENDMENT TO FINANCING AGREEMENT This Fifth Amendment to Financing Agreement (this "Amendment") is entered into as of February 14, 2003 among FACTORY 2-U STORES, INC., a Delaware corporation ("Company"), the Lenders who are a party to the Financing Agreement referred to below (collectively, "Lenders") and THE CIT GROUP/BUSINESS CREDIT, INC., a New York corporation ("Agent"), in its capacity as Agent for the Lenders, with reference to the following facts: A. Agent, Company and Lenders previously entered into that certain Financing Agreement dated as of March 3, 2000, as amended by that certain First Amendment to Financing Agreement dated as of April 13, 2000, that certain Second Amendment to Financing Agreement dated as of April 10, 2001, that certain Third Amendment to Financing Agreement dated as of April 9, 2002, and that certain Fourth Amendment to Financing Agreement dated as of September 16, 2002 (collectively, the "Financing Agreement"), pursuant to which Lenders have provided Company with certain loans and other financial accommodations. B. Company has requested that Agent and Lenders amend the Financing Agreement to, among other things, expand the scope of the Collateral securing the Obligations in consideration of Agent agreeing to cause an Issuing Bank to issue one or more Letters of Credit or Agent agreeing to issue one or more guaranties (collectively, the "Factor Letters of Credit and Guaranties"), in favor of the factor or factors of certain of the Company's suppliers' accounts receivable (which accounts receivable constitute accounts payable of the Company), to secure performance by the Company of certain of such accounts payable. C. Agent and Lenders are willing to amend the Financing Agreement on the terms and subject to the conditions set forth in this Amendment. NOW THEREFORE, in consideration of the foregoing and the terms and conditions hereof, the parties do hereby agree as follows, effective as of the date set forth above: 1. Definitions. Terms used herein, unless otherwise defined herein, shall have the meanings set forth in the Financing Agreement. 2. Amendments to Financing Agreement. (a) The definition of "Collateral" set forth in Section 1 of the Financing Agreement is hereby amended and restated in its entirety to read as follows, and the Company confirms its grant of a security interest in such Collateral to secure the Obligations: "Collateral" shall mean all present and future Accounts, Inventory, Other Collateral, equipment (as defined in the UCC), general intangibles (as defined in the UCC and expressly including all payment intangibles and including all tax refunds and rights to tax refunds, including the Tax Refund), letter of credit rights (as defined in the UCC), investment property (as defined in the UCC), and documents (as defined in the UCC and including any and all warehouse receipts, bills of lading, shipping documents, chattel paper, instruments and similar documents, all whether negotiable or not and all goods and Inventory relating thereto), and all cash and non-cash proceeds of the foregoing. (b) Section 1 of the Financing Agreement is hereby amended to add the following definition of "Factor Letters of Credit and Guaranties": "Factor Letters of Credit and Guaranties" shall mean the Letters of Credit issued by an Issuing Bank, as guaranteed by Agent, on behalf of Lenders, and Guaranties issued by Agent, in either case in favor of Company's suppliers' factor or factors in amounts not to exceed $2,500,000 in the aggregate to secure performance by Company of certain of its accounts payable. (c) Section 1 of the Financing Agreement is hereby amended to add the following definition of "Factor Letters of Credit and Guaranties Reserve": "Factor Letters of Credit and Guaranties Reserve" shall mean the Availability Reserve established by Agent with respect to the Factor Letters of Credit and Guaranties. (d) Section 1 of the Financing Agreement is hereby amended to replace the definition of "Letter of Credit Sub-Line" with the following: "Letter of Credit Sub-Line" shall mean $15,000,000 in the aggregate. (e) Section 1 of the Financing Agreement is hereby amended to add the following definition of "Tax Refund": "Tax Refund" shall mean the Company's federal income tax refund currently pending with the Internal Revenue Service with respect to tax year 2002. 3. Factor Letters of Credit and Guaranties; Availability Reserve. Lenders agree that Agent, on behalf of Lenders, shall facilitate the issuance of, or issue, the Factor Letters of Credit and Guaranties, respectively. Lenders further agree that no Factor Letters of Credit and Guaranties Reserve will be imposed until the earlier of (a) the receipt by Agent, for the benefit of Lenders, of either the Tax Refund or the proceeds arising from of any assignment of the Tax Refund in compliance with Section 5 hereof, and (b) April 15, 2003. The amount of the Factor Letters of Credit and Guaranties Reserve shall be the amount which Agent determines in its discretion is appropriate in light of the contingent reimbursement obligations of the Lenders to the Issuing Bank and the contingent obligations of Agent and Lenders with respect to the Factor Letters of Credit and Guaranties, including such contingent obligations as may result from preference risks of the factor or factors holding the Factor Letters of Credit and Guaranties, provided that the amount of the Factor Letters of Credit and Guaranties Reserve will not exceed the largest aggregate amount of the Factor Letters of Credit and Guaranties which is or was outstanding at any time. 4. Consent to Subordinated Debt. Agent and Lenders hereby consent to the incurrence by Company of up to $10,000,000 of indebtedness which may be secured by a lien upon the Collateral junior to that held by Agent, for the benefit of Lenders, and otherwise on terms and conditions, including subordination provisions and execution of an intercreditor agreement all acceptable to Agent in its discretion. 5. Disposition of Certain Assets. Agent and Lenders hereby consent to the sale or other disposition of the Tax Refund and the Company's equipment and fixtures at its distribution center in Otay Mesa, San Diego, California, which consent is expressly conditioned upon: (a) the terms and provisions of the sale or other disposition shall be acceptable to Agent, in its reasonable discretion, in all respects; and (b) all proceeds of any such disposition shall be paid directly to Agent, for the benefit of Lenders, by the purchaser/transferee of any of such assets. 6. Fees. Company shall pay to Agent, for the benefit of Lenders, fees with respect to the Factor Letters of Credit and Guaranties as follows: (x) prior to the date which is the earlier of (a) the receipt by Agent, for the benefit of Lenders, of the Tax Refund, and (b) April 15, 2003, a fee equal to the sum of (i) $1,000 per Business Day, payable monthly, in arrears, plus (ii) 1.5% per annum, payable monthly in arrears, of the aggregate amount of the Factor Letters of Credit and Guaranties, and (y) after the date which is the earlier of (a) the receipt by Agent, for the benefit of Lenders, of the Tax Refund, and (b) April 15, 2003, a fee equal to 1.5% per annum, payable monthly in arrears, of the amount of the Factor Letters of Credit and Guaranties. 7. Conditions Precedent. The effectiveness of the foregoing amendment shall be, and hereby is, subject to the fulfillment to Agent's satisfaction of the Conditions Precedent. The "Conditions Precedent" shall mean each of the following: (a) Receipt by Agent of this Amendment duly executed by each of the parties hereto; and (b) As of the date hereof, the representations and warranties contained in Section 7 of the Financing Agreement are (before and after giving effect to this Amendment) true and correct in all material respects (except to the extent any such representation and warranty is expressly stated to have been made as of a specific date, in which case it shall be true and correct as of such specific date) and no Default or Event of Default shall be existing or have occurred and be continuing. 2 5. Miscellaneous. (a) Reference to and Effect on the Financing Agreement. (i) Except as specifically amended by this Amendment and the documents executed and delivered in connection herewith, the Financing Agreement shall remain in full force and effect and is hereby ratified and confirmed. (ii) The execution and delivery of this Amendment shall not, except as expressly provided herein, constitute a waiver of any provision of, or operate as a waiver of any right, power or remedy of Agent or any Lender under the Financing Agreement or any agreement or document executed in connection therewith. (iii) Upon the Conditions Precedent being satisfied, this Amendment shall be construed as one with the existing Financing Agreement, and the existing Financing Agreement shall, where the context requires, be read and construed throughout so as to incorporate this Amendment. (b) Fees and Expenses. The Borrower acknowledges that all costs, fees and expenses incurred in connection with this Amendment will be paid in accordance with Section 8.5 of the Financing Agreement. (c) Headings. Section and subsection headings in this Amendment are included for convenience of reference only and shall not constitute a part of this Amendment for any other purpose or be given any substantive effect. (d) Counterparts. This Amendment may be executed in one or more counterparts, each of which shall be deemed an original but all of which together shall constitute one and the same instrument. (e) Governing Law. This Amendment shall be governed by and construed according to the laws of the State of California. IN WITNESS WHEREOF, the parties hereto have executed this Amendment as of the date first above written. Company: FACTORY 2-U STORES, INC. By: /s/ Douglas C. Felderman Name: Douglas C. Felderman Title: Executive Vice President and Chief Financial Officer Agent and Lender: THE CIT GROUP/BUSINESS CREDIT, INC. By: /s/ Frank Brown Name: Frank Brown Title: Vice President 3 EX-10 4 exh6thamend.txt 6TH AMENDMEND TO THE CIT FINANCING AGREEMENT Exhibit 10.11 SIXTH AMENDMENT TO FINANCING AGREEMENT This Sixth Amendment to Financing Agreement (this "Sixth Amendment") is entered into as of April 10, 2003 by and among FACTORY 2-U STORES, INC., a Delaware corporation ("Company"), THE CIT GROUP/BUSINESS CREDIT, INC., a New York corporation, in its capacity as Agent ("Agent") under the Financing Agreement (defined below); THE CIT GROUP/BUSINESS CREDIT, INC., a New York corporation, in its capacity as the Tranche A Lender (collectively, together with any other Persons who may subsequently become a Tranche A Lender, the "Tranche A Lenders"); and GB RETAIL FUNDING, LLC, a Massachusetts limited liability company in its capacity as the Tranche B Lender (together with any other Persons who may subsequently become a Tranche B Lender, the "Tranche B Lender"); (collectively, the Tranche A Lenders and the Tranche B Lender shall be referred to herein as the "Lenders"). Witnesseth - ---------- A. Agent, Company and the Tranche A Lenders have previously entered into that certain Financing Agreement dated as of March 3, 2000, as amended by that certain First Amendment to Financing Agreement dated as of April 13, 2000, that certain Second Amendment to Financing Agreement dated as of April 10, 2001, that certain Third Amendment to Financing Agreement dated as of April 9, 2002, that certain Fourth Amendment to Financing Agreement dated as of September 16, 2002 ("Fourth Amendment"), and that certain Fifth Amendment to Financing Agreement dated as of February 14, 2003 ("Fifth Amendment") (as so amended, and as it may be further modified, amended, restated or supplemented, the "Financing Agreement"), pursuant to which the Tranche A Lenders have provided Company with certain Revolving Loans (as defined in the Financing Agreement) and other financial accommodations. B. The Company has requested that the Tranche B Lender provide it with Seven Million Five Hundred Thousand Dollars ($7,500,000) in junior secured loans, and the Tranche B Lender has agreed to provide such Loans, subject to the terms and conditions set forth in this Sixth Amendment to Financing Agreement. C. The Agent and Tranche A Lenders consent to the Company's receipt of such loans from the Tranche B Lender, on the terms and conditions set forth herein, in the Agency Agreement (defined below) and other Loan Documents. D. The Company, Agent and Lenders desire to amend the Financing Agreement on the terms and subject to the conditions set forth in this Sixth Amendment. NOW THEREFORE, in consideration of the foregoing and the terms and conditions hereof, the parties do hereby agree as follows, effective as of the date set forth above: 1. Definitions. Capitalized terms used herein and not defined or amended herein shall have the same meaning as in the Financing Agreement. (A) Existing Definitions: The following existing definitions in the Financing Agreement are hereby amended as follows: "Availability": shall mean at any time the result of the following: (A) the Borrowing Base, minus (B) the then outstanding balance of all Tranche A Obligations, minus (C) the then Stated Amount of all outstanding Letters of Credit, minus (D) the Availability Reserve; minus (E) the Availability Block. "Availability Reserve": The existing definition of "Availability Reserve" in the Financing Agreement is hereby deleted and the following inserted in its place: "Availability Reserves" shall mean such reserves as may be established by the Agent as it deems necessary in its commercially reasonable discretion to reflect (i) negative forecasts and/or trends in the Company's business, profits, operations or financial condition that could reasonably be expected to have a Material Adverse Effect on the Company or the Agent's ability to realize on the Collateral or (ii) other issues, circumstance or facts that could otherwise negatively impact the Company, its business, profits, operations or financial conditions or assets or its ability to realize on the Collateral. Availability Reserves shall initially be based on the following: (a) delinquent sales taxes, (b) delinquent rental payments for the Company's leased premises (other than with respect to Closed Stores) and a reserve of up to two (2) months rent for any retail store location in Washington State for which a satisfactory landlords' waiver has not been obtained and, (c) accrued but unpaid ad valoreum taxes. "Borrowing Base": The existing definition of "Borrowing Base" is hereby deleted and such term shall hereafter refer to the least of (A) the Tranche A Loan Ceiling; (B) the Tranche A Borrowing Base; and (C) the Overall Borrowing Base. "Customary Permitted Liens": In addition to those liens listed in subparagraphs (a), (b) and (c) of the existing definition "Customary Permitted Liens" shall include the following: (d) encumbrances in favor of the Agent as security for the Obligations; and (e) those encumbrances listed on Schedule 1 annexed hereto. "Early Termination Date": shall include, in addition to the existing text thereof, the date on which any of the events referred to in Sections 10.1(b), (c) and (d) shall occur, but shall exclude a Change of Control under Section 10.1(q) hereof. "Early Termination Fee": The existing definition of "Early Termination Fee" is hereby redenominated to mean "Tranche A Early Termination Fee". "EBITDA": The existing definition of "EBITDA" is deleted and replaced with the following: EBITDA shall mean the Company's net income for any period, plus the following, to the extent deducted in calculating net income: (i) interest expense (net of interest income), (ii) income tax expense, (iii) depreciation expense, (iv) amortization expense, (v) non-cash extraordinary losses and losses on the sale of assets outside the ordinary course of business, and (vi) non-cash stock option compensation charges and the effect of extraordinary and/or non-recurring gains or losses for such period, all as determined in accordance with GAAP) on a basis consistent with the latest audited financial statements of the Company. 2 "Eligible In-Transit Inventory" shall only apply to Inventory being shipped to the Company from a location in the United States and not from a foreign location. "Eligible Inventory": In addition to the reserves specified in subparagraph (h) of such definition, the Agent may establish reserves for lay-away items and gift cards; provided, however, that initially a reserve for gift cards shall be established only if the outstanding amount thereof exceeds three hundred thousand dollars ($300,000) and a reserve for lay-a-way items shall only be established at any time that the aggregate amount of Inventory subject to lay-a-way programs exceeds four hundred thousand dollars ($400,000) and in each case shall be equal to the amount of Eligible Inventory in such categories in excess of such thresholds (subject in each case to adjustment from time to time in the Agent's reasonable discretion). "Fifth Amendment": The Fifth Amendment to the Financing Agreement dated as of February 14, 2003. "Fourth Amendment": The Fourth Amendment to the Financing Agreement dated as of September 16, 2002. "Lenders": shall refer collectively to the Tranche A Lenders and the Tranche B Lender except for the following Sections where the references to "Lenders" are hereby amended to refer solely to the "Tranche A Lenders": Sections 3.1, 3.8, all of Section 5, Sections 8.1 - 8.11, (inclusive), and Paragraph 3 of the Fifth Amendment. "Obligations": The definition of Obligations is intended to mean and is hereby amended, to include, without limitation, any and all amounts owed to the Tranche A Lenders and the Tranche B Lender including, but not limited to, the Tranche A Obligations and the Tranche B Obligations. "Out-of-Pocket Expenses": shall include all Out-of-Pocket Expenses incurred by the Agent and each Lender and shall include without limitation, the Agent's internal audit fees based on its then current per diem/per auditor charges, not to exceed five thousand dollars ($5,000) per audit. "Permitted Indebtedness": In addition to the categories of Indebtedness specified as being "Permitted Indebtedness" in the Financing Agreement, Permitted Indebtedness shall include all Indebtedness secured by a Permitted Encumbrance. The requirements in subparagraph (f) of the definition of Permitted Indebtedness in respect to Indebtedness arising from sale/leaseback transaction or loans secured by the Company's equipment shall include, in addition to those specified in subsections (i) - (iv) thereof, the following which shall be referenced as subparagraph (f)(v) of such definition: (v) the net cash proceeds from such sale/leaseback or loan transaction shall be paid to the Agent for distribution to the Lenders to the extent required under Section 8.15 of the Financing Agreement. "Required Lenders": Until the Tranche B Obligations are paid in full, Required Lenders shall mean the consent of such Lenders as is required pursuant to the Agency Agreement. Thereafter, the existing definition shall apply. "Revolving Loans" shall refer to advances made by the Tranche A Lenders, from time to time, to or for the account of the Company by the Agent on behalf of the Tranche A Lenders pursuant to Section 3 of this Financing Agreement. "Triggering Availability": The existing definition of Triggering Availability is deleted and replaced with the following: 3 Triggering Availability shall mean at any time the excess of the Tranche A Borrowing Base (determined without regard to the Tranche A Loan Ceiling) over the sum of (x) the outstanding aggregate amount of all Tranche A Obligations, plus (y) the Availability Reserve, plus (z) the Availability Block. (B) New Definitions: The following defined terms are hereby added to the Financing Agreement: "Agency Agreement": shall mean that certain Agency Agreement dated as of April 10, 2003 by and among the Agent, the Tranche A Lenders and the Tranche B Lenders. "Availability Block" shall mean Seven Million Five Hundred Thousand Dollars ($7,500,000). "Blocked Account" as defined in Section 7.1(A)(xxi) hereof. "Capital Expenditures": shall mean the expenditure of funds or the incurrence of liabilities for the acquisition of property, plant, equipment, furniture, fixtures, leasehold improvements and software which are capitalized in accordance with GAAP and are consistent with the Company's business plan in the aggregate. "Change of Control": shall mean (a) the acquisition by any group of Persons of beneficial ownership of 50% or more of the issued and outstanding capital stock of the Company having the right, under ordinary circumstances, to vote for the election of directors of the Company; (b) more than one-half (1/2) of the Persons who were directors of the Company on the first day of any period consisting of twelve (12) consecutive calendar months shall cease for any reason, other than death or disability, to be directors of the Company and successors for such directors have not been approved by a majority of the directors of the Company still in office who were directors at the beginning of such period or whose election or nomination was so approved or (c) any merger or consolidation of the Company of or with any other Person or the sale of all or substantially all of the property, assets or capital stock of the Company. "Closed Stores": The retail store locations denoted as already having been closed on updated Schedule 2 hereto. "Distribution Center Property": shall mean any location at which the Company now or hereafter operates a distribution center or warehouse, which, at present, consist of the following locations. 4000 Ruffin Road, San Diego, California 92123 7130 Miramar Road, San Diego, California 92121 1875 Waters Ridge Drive, #200, Lewisville, TX 75057 2020 Piper Ranch Road, Otay Mesa, California 92173 "Inventory Reserves" shall mean the reserves which the Agent is permitted to establish in respect to Inventory under Subsection (h) of the definition of Eligible Inventory. "Knowledge" shall mean the actual knowledge of the Company's current senior management. "Loan Documents": This Financing Agreement, the Agency Agreement and each instrument and document previously, now or subsequently executed and/or delivered in conjunction with this Financing Agreement and each other instrument or document from time to time executed and/or delivered in connection with the arrangements contemplated hereby. "Material Adverse Change": Any event, fact, circumstance, change in, or effect on, the business of the Company, taken as a whole, which individually or in the aggregate or on a cumulative basis with any other then existing events, facts, circumstances, changes in, or effects on, the Company or the Collateral, taken as a whole: 4 (a) would reasonably be expected to material adversely affect the ability of the Company, to (i) operate or conduct its business in all material respects in the manner in which such business is currently operated or conducted, or (ii) perform its obligations under the Loan Documents; or (b) would reasonably be expected to have a material adverse effect on the value, enforceability, or collectibility of a material portion of the Collateral. "Material Adverse Effect": a result, consequence, or outcome which constitutes a Material Adverse Change. "Overall Borrowing Base": Shall equal the sum of the following as of any date as in effect on such date: (A) The aggregate value of Eligible Inventory (including Eligible In Transit Inventory) determined at the lower of cost or market on a first-in, first-out basis multiplied by the Overall Inventory Advance Percentage; provided, however, that in no event shall the value of Eligible in-Transit Inventory included in the Overall Borrowing Base exceed the lesser of (a) $5,000,000 or (b) 40% of the aggregate value of Eligible Inventory; plus (B) Eighty-Five Percent (85%) of the outstanding Eligible Accounts Receivable of the Company, minus (C) the then outstanding balance of principal due on Tranche B Loan I. "Overall Inventory Advance Percentage" shall mean the lower of (a) seventy nine and two-tenths percent (79.2%) of the aggregate value of Eligible Inventory or (b) one hundred percent (100%) of the Net Orderly Liquidation Value of Eligible Inventory as a percentage of the total Inventory as determined by the most recent Inventory appraisal, as provided for in Section 7.13 hereof. "Overloan": as defined in the Agency Agreement. "Permissible Overloans": As defined in the Agency Agreement. "Person": Any natural person, any corporation, limited liability company, trust, partnership, joint venture or other enterprise or entity. "Piper Distribution Center Property": shall mean the Distribution Center located at 2020 Piper Ranch Road, Otay Mesa, California 92173. "Piper Tranche B Senior Collateral": shall mean all Tranche B Senior Collateral located on or used in connection with the Piper Distribution Center Property. "Sixth Amendment": The Sixth Amendment to the Financing Agreement dated as of April 10, 2003. "Stated Amount": The maximum amount for which a Letter of Credit may be honored. 5 "Tranche A Borrowing Base": shall equal the sum of the following as of any date (but not to exceed the Tranche A Loan Ceiling): (A) Eighty-Five Percent (85%) of the outstanding Eligible Accounts Receivable of the Company, Plus (B) the aggregate value of Eligible Inventory (including Eligible In-Transit Inventory) determined at the lower of cost or market on a first-in, first-out basis, multiplied by the Inventory Advance Percentage; provided, however, that in no event shall the value of Eligible In-Transit Inventory included in the Tranche A Borrowing Base exceed the lesser of (a) $5,000,000 or (b) forty percent (40%) of the aggregate value of Eligible Inventory. "Tranche A Commitment": shall mean, with respect to each Tranche A Lender, that respective Tranche A Lender's Tranche A Dollar Commitment. "Tranche A Debt": shall mean the aggregate of the Company's Obligations, and indebtedness of any character to the Tranche A Lenders that arise from or are related to Tranche A Loans, including without limitation any Overloans and Tranche A Fees. "Tranche A Dollar Commitment": As set forth under the signature block for each Tranche A Lender for this Sixth Amendment (as such amounts may change in accordance with the provisions of this Agreement), provided, however, that the aggregate of Tranche A Dollar Commitments shall not exceed the Tranche A Loan Ceiling. "Tranche A Early Termination Fee": is defined in Section 11.2 of this Financing Agreement. "Tranche A Fees" shall mean all fees (such as the Letter of Credit Guaranty Fee, Loan Facility Fee, Collateral Management Fee, Documentation Fee, Loan Facility Fee, Line of Credit Fee and the Tranche A Early Termination Fee and any fee payable to the Agent or Tranche A Lenders in connection with an amendment or waiver of a provision of this Agreement) payable by the Company to the Agent, Tranche A Lenders or their Affiliates in respect of the Tranche A Loans including any fee payable to any Affiliate of the Agent or Tranche A Lenders on account of the issuance of Letters of Credit pursuant to this Financing Agreement. "Tranche A Lenders": shall mean each Tranche A Lender to which reference is made in the Preamble of the Sixth Amendment and any other Person who becomes a "Tranche A Lender" in accordance with the provisions of this Financing Agreement. "Tranche A Loans": shall mean all Revolving Loans made hereunder. "Tranche A Loan Ceiling": shall mean Fifty Million Dollars ($50,000,000) as such ceiling may be increased or decreased in accordance with the terms of the Loan Documents to which the Company is a party. "Tranche A Maturity Date" shall mean March 3, 2006. "Tranche A Obligations": shall mean the aggregate of Tranche A Debt and Tranche A Fees. "Tranche A Percentage Commitment": As set forth under the signature block for each Tranche A Lender for such Tranche A Lender reflecting, the ratio of (i) the amount of the Tranche A Dollar Commitment of such Tranche A Lender to (ii) the aggregate amount of the Tranche A Dollar Commitments of all Tranche A Lenders (as such percentage may change in accordance with the provisions of this Agreement). 6 "Tranche A Senior Collateral": shall mean all Collateral which is not Tranche B Senior Collateral. "Tranche B Anniversary Fee": Defined in the Tranche B Fee Letter. "Tranche B Commitment Fee": Defined in the Tranche B Fee Letter. "Tranche B Debt": shall mean the aggregate of the Company's Obligations, and indebtedness of any character to the Tranche B Lender that arise from or are related to the Tranche B Loans, including, but not limited to, Tranche B Fees. "Tranche B Early Termination Fee": The fee payable pursuant to Section 8.14 hereof. "Tranche B Fees" shall mean all fees (such as the Tranche B Commitment Fee, Tranche B Anniversary Fee and Tranche B Early Termination Fee payable by the Company in respect of the Tranche B Debt pursuant to the Tranche B Fee Letter or Sections 8.13 or 8.14 hereof. "Tranche B Fee Letter" shall mean the letter from the Tranche B Lender to the Company dated the date hereof concerning the fees due from the Company to the Tranche B Lender, as such letter may be amended, restated, modified or supplemented. "Tranche B Loans" shall mean collectively Tranche B Loan I and Tranche B Loan II. "Tranche B Loan I": shall mean the loan in the original principal amount of Six Million Five Hundred Thousand Dollars ($6,500,000) evidenced by Tranche B Note I. "Tranche B Loan II" shall mean the Loan in the original principal amount of One Million Dollars ($1,000,000) evidenced by Tranche B Note II. "Tranche B Notes": shall mean collectively, Tranche B Term Note I and Tranche B Term Note II. "Tranche B Maturity Date" shall mean April 10, 2004, which date may be extended pursuant to Section 11.1 hereof. "Tranche B Term Note I": shall mean the note dated the date hereof evidencing Tranche B Term Loan I in the original principal amount of Six Million Five Hundred Thousand Dollars ($6,500,000). "Tranche B Term Note II" shall mean the note dated the date hereof evidencing Tranche B Term Loan II in the original principal amount of One Million Dollars ($1,000,000). "Tranche B Senior Collateral": shall mean (i) all furniture, fixtures, machinery and equipment of the Company and (ii) all products, proceeds (including, without limitation, all leases and rents arising therefrom), substitutions and accessions of or to any of the foregoing, wherever located and whether cash or non-cash. 2. Conditions Precedent. The obligation of the Agent and each of the Lenders to make loans under the Financing Agreement is subject to the satisfaction of, or waiver of, immediately prior to or concurrently with the making of such loans, each of the conditions precedent set forth in Sections 2.1(a-t inclusive) of the Financing Agreement as of the effective date of this Sixth Amendment. Without limitation of the generality of the foregoing, on or before the effective date of this Sixth Amendment, the Company shall furnish the Agent with the following items: 7 (a) The Agent shall have received updated copies of the Searches referenced in Subsection 2.1(a) of the Financing Agreement through a date substantially contemporaneous with the effective date hereof and such searches shall have confirmed that Agent has a duty perfected, first lien on the Collateral pursuant to Section 2.1(b) of the Financing Agreement. (b) The Agent shall have received evidence reasonably satisfactory to the Agent that casualty insurance policies listing the Agent and each of the Lenders, as additional insureds and loss payees are in full force and effect and that such policies comply with Section 7.5 of the Financing Agreement. (c) Pursuant to Subsection 2.1(c) of the Financing Agreement, any additional UCC filings required to perfect the security interest of the Agent in the Collateral shall have been properly filed in each applicable jurisdiction. (d) The Company's counsel shall have furnished the Agent and each of the Lenders with a satisfactory legal opinion as referenced in Subsection 2.1(d) of the Financing Agreement. (e) The Company shall have confirmed that the Subordination Agreements referenced in Subsection 2.1(f) of the Financing Agreement remain in full force and effect and extend to the Tranche B Loans and shall have delivered on April, 2003 Acknowledgement Agreement in respect to each such Subordination Agreements. (f) The Agent shall have received a landlord's waiver for the Piper Distribution Center Property or the Company shall have satisfied the Agent that it shall make diligent efforts to obtain such waiver within thirty (30) days following the effective date. (g) The Agent shall have been satisfied that the bailee agreements referenced in Subsection 2.1(h) of the Financing Agreement remain in full force and effect and shall have satisfied Agent that it shall make diligent efforts to obtain any other bailee agreements Agent reasonably deems necessary within thirty (30) days following the effective date. (h) The Agent shall have received updated Board Resolutions, Incumbency Certificate and related documents of the kind referenced in Subsection 2.1(i) of the Financing Agreement shall have been provided to the Agent in respect to this Sixth Amendment and the documents being executed and delivered in conjunction therewith. (i) The Agent shall have received updated corporate organizational documents of the type referenced in Subsection (j) of the Financing Agreement shall have been updated through a date substantially contemporaneous with the effective date. (j) The Company shall have delivered an updated Officers Certificate as referenced in Subsection 2.1(k) as of the effective date. (k) The provisions of Subsections 2.1(l), (m), (o) and (q) of the Financing Agreement shall each have been satisfied. (l) Agent and each Lender shall have received, reviewed and be satisfied with the twelve month cash budget projection referenced in Subsection 2.1(p) of the Financing Agreement for the Company's 2003 fiscal year, ended January 31, 2004. (m) The Company agrees that within thirty (30) days of the date hereof, at the Company's expense (not to exceed $7,500 in the aggregate for Agent's and all Lenders' Counsel), the Agent's counsel shall prepare and the parties shall each execute an Amended and Restated Financing Agreement incorporating this Sixth Amendment and all prior amendments to the Financing Agreement. 8 In addition, the obligations of the Tranche B Lender to advance the Tranche B Loan is subject to the following additional conditions precedents: (n) After giving effect to all outstanding Tranche A Loans and the funding of the Tranche B Loans and payments to be made or expenses incurred in connection with this Sixth Amendment, Availability shall not be less than $15,000,000. (o) All reasonable fees and expenses related to the Sixth Amendment of the Agent's and the Tranche B Lender's counsel shall have been paid. (p) The Company shall have executed and delivered the Tranche B Notes, the Tranche B Fee Letter and any and all other documents or instruments which may be reasonably requested by the Agent or Tranche B Lender. (q) The Agent and each Lender shall have executed and delivered the Agency Agreement. (r) The Agent shall have received such additional blocked account agreements, Credit Card Acknowledgements and Credit Card Agreements as it may reasonably request or shall be reasonably satisfied that the Company has made satisfactory arrangements to obtain such documents within thirty (30) days following the effective date. 3. Amendments to Section 3. (a) The parties acknowledge that Section 3.1 of the Financing Agreement is hereby amended to provide as follows: Section 3.1 The Tranche A Lenders agree, subject to terms and conditions of this Financing Agreement from time to time to make Revolving Loans to the Company on a revolving basis (i.e., subject to the limitations set forth herein, the Company may borrow, repay and re-borrow such Revolving Loans). The amount of the Revolving Loans available to be advanced to the Company shall be equal to Availability, as determined by the Agent from time to time. Each request from the Company for a Revolving Loan shall constitute, unless otherwise disclosed in writing to the Agent and the Tranche A Lenders, a representation and warranty by the Company that after giving effect to the requested advance, no Default or Event of Default shall have occurred and that such requested Revolving Loan is within the Availability that then exists. All requests for Revolving Loans and advances must be received by an Officer of the Agent no later than 1:00 p.m., New York time of the Business Day on which such loan and advances are required. Should the Agent for any reason honor any request for advances in excess of Availability, such advances shall be considered "Overadvances." The Agent and Tranche A Lenders acknowledge that the Agent shall be permitted to make an Overadvance hereunder, without the Tranche B Lender's consent, only if, and to the extent permitted under the Agency Agreement. (b) The following new Section 3.1A is hereby added to the Financing Agreement. 3.1(A) Subject to the terms hereof, the Tranche B Lender agrees to advance the Tranche B Loans to the Company on the date hereof consisting of the Tranche B Loan I in the amount of Six Million Five Hundred Thousand Dollars ($6,500,000) and Tranche B Loan II in the amount of One Million Dollars ($1,000,000). (c) All references to "Revolving Loan Account" in Section 3.6 or other provisions of the Financing Agreements or Loan Documents are hereby amended to read "Loan Account" and such Loan Account shall include the Tranche B Obligations in addition to the Tranche A Obligations. 9 (d) The Agent shall send a copy of the monthly statement referred to in Section 3.7 hereof to the Tranche B Lender simultaneously with sending it to the Company. 4. Amendments to Section 6. (a) The Company hereby confirms that the security interests in the Collateral granted to the Agent pursuant to Section 6.1 of the Financing Agreement is intended to secure all of the Obligations of the Company to the Agent and each Lender, including, but not limited to, all Tranche A Obligations and all Tranche B Obligations and in confirmation thereof, the Company hereby pledges to the Agent, for the benefit of all of the Lenders (including the Tranche A Lenders and the Tranche B Lenders), a continuing lien and security interest in all of the Collateral to secure all of the Obligations (including, but not limited to, the Tranche A Obligations and the Tranche B Obligations). (b) The following is hereby added as Section 6.8 of the Financing Agreement: 6.8(a) The Company irrevocably and unconditionally authorizes and grants a power of attorney to the Agent to file at any time and from time to time such financing statements with respect to the Collateral naming the Agent or its designee as the secured party and such Company as debtor, as the Agent may require, and including any other information with respect to the Company or otherwise required by part 5 of Article 9 of the UCC of such jurisdiction as the Agent may determine, together with any amendments and continuations with respect thereto (including, but not limited to, amendments of the UCC financing statements previously filed in favor of the CIT Group/Business Credit, Inc. to reflect the assignment thereof to the Agent as secured party), which authorization shall apply to all financing statements filed on, prior to or after the date hereof. The Company hereby ratifies and approves all financing statements naming any Tranche A Lenders or the Agent or its designee as secured party and the Company as debtor with respect to the Collateral (and any amendments with respect to such financing statements) filed by or on behalf of Agent or any Lender prior to the date hereof and ratifies and confirms the authorization of the Agent to file such financing statements (and amendments, if any) and amendments reflecting the assignment thereof to the Agent, on behalf of all of the Lenders. In no event shall the Company, without the consent of the Agent (which may not be unreasonably withheld), at any time file, or permit or cause to be filed, any correction statement or termination statement with respect to any previously filed financing statement (or amendment or continuation with respect thereto) naming the Agent or the Tranche A Lenders or their respective designees as secured party and the Company as debtor. (b) The Company does not have any chattel paper (whether tangible or electronic) or instruments as of the date hereof. In the event that the Company shall be entitled to or shall receive any chattel paper or instrument after the date hereof, the Company shall promptly notify the Agent thereof in writing. Promptly upon the receipt thereof by or on behalf of the Company (including by any agent or representative), the Company shall deliver, or cause to be delivered to the Agent, all tangible chattel paper and instruments that the company may at any time acquire, accompanied by such instruments of transfer or assignment duly executed in blank as the Agent may from time to time specify, in each case except as the Agent may otherwise agree. At the Agent's option, the Company shall, or the Agent may at any time on behalf of the Company , cause the original of any such instrument or chattel paper to be conspicuously marked in a form and manner acceptable to the Agent with the following legend referring to chattel paper or instruments as applicable: "This chattel paper instrument is subject to the security interest of CIT Group/Business Credit Inc., as Agent and any sale, transfer, assignment or encumbrance of this chattel paper instrument violates the rights of such secured party." (c) In the event that the Company shall at any time hold or acquire an interest in any electronic chattel paper or any "transferable record" (as such term is defined in Section 201 of the Federal Electronic Signatures in Global and National Commerce Act or in Section 16 of the Uniform Electronic Transactions Act as in effect in any relevant jurisdiction), the Company shall promptly notify the Agent thereof in writing. Promptly upon the Agent's request, the company shall take, or cause to be taken, such actions as the Agent may reasonably request to give the Agent control of such electronic chattel paper under Section 9-105 of the UCC and control of such transferable record under Section 201 of the Federal Electronic Signatures in Global and National Commerce Act or, as the case may be, Section 16 of the Uniform Electronic Transactions Act, as in effect in such jurisdiction. 10 (d) The Company does not own or hold, directly or indirectly, beneficially or as record owner or both, any investment property, as of the date hereof, or have any investment account, securities account, commodity account or other similar account with any bank or other financial institution or other securities intermediary or commodity intermediary as of the date hereof (except for a money market account maintained at Bank of America, the balance of which shall not exceed $10,000 unless and until documentation sufficient to grant the Agent a perfected first lien security interest in such account and all funds deposited therein for the benefit of the Lenders has been executed and delivered to the Agent.). (i) In the event that the Company shall be entitled to or shall at any time after the date hereof hold or acquire any certificated securities, the Company shall promptly endorse, assign and deliver the same to the Agent, accompanied by such instruments of transfer or assignment duly executed in blank as the Agent may from time to time specify. (ii) The Company shall not, directly or indirectly, after the date hereof open, establish or maintain any investment account, securities account, commodity account or any other similar account (other than a deposit account) with any securities intermediary or commodity intermediary unless each of the following conditions is satisfied: (A) the Agent shall have received not less than five (5) Business Days prior written notice of the intention of the Company to open or establish such account which notice shall specify in reasonable detail and specificity acceptable to the Agent the name of the account, the owner of the account, the name and address of the securities intermediary or commodity intermediary at which such account is to be opened or established, the individual at such intermediary with whom the Company is dealing and the purpose of the account, (B) the securities intermediary or commodity intermediary (as the case may be) where such account is opened or maintained shall be acceptable to the Agent, and (C) on or before the opening of such investment account, securities account or other similar account with a securities intermediary or commodity intermediary, the Company shall as the Agent may specify either (1) execute and deliver, and cause to be executed and delivered to the Agent, an Investment Property Control Agreement with respect thereto duly authorized, executed and delivered by the Company and such securities intermediary or commodity intermediary or (2) arrange for the Agent to become the entitlement holder with respect to such investment property on terms and conditions acceptable to the Agent; provided, however, that subject to the terms of this Agreement, the Company shall retain the right to liquidate or otherwise dispose of such investment property unless and until an Event of Default has occurred and is continuing so long as the Company makes arrangements to grant the Agent a perfected security interest in the proceeds thereto. (e) The Company is not the beneficiary or otherwise entitled to any right to payment under any letter of credit, banker's acceptance or similar instrument as of the date hereof. In the event that the Company shall be entitled to or shall receive any right to payment under any letter of credit, banker's acceptance or any similar instrument, whether as beneficiary thereof or otherwise after the date hereof, the Company shall promptly notify the Agent thereof in writing. The Company shall immediately, as the Agent may specify, either (i) deliver, or cause to be delivered to the Agent, with respect to any such letter of credit, banker's acceptance or similar instrument, the written agreement of the issuer and any other nominated person obligated to make any payment in respect thereof (including any confirming or negotiating bank), in form and substance satisfactory to the Agent, consenting to the assignment of the proceeds of the letter of credit to the Agent by the Company as security and agreeing to make all payments thereon directly to the Agent or as the Agent may otherwise direct or (ii) cause the Agent as secured party to become, at the Company's expense, the transferee beneficiary of the letter of credit, banker's acceptance or similar instrument (as the case may be). 11 (f) The Company does not have any commercial tort claims as of the date hereof. In the event that the Company shall at any time after the date hereof have any commercial tort claims, the Company shall promptly notify the Agent thereof in writing, which notice shall (i) set forth in reasonable detail the basis for and nature of such commercial tort claim and (ii) include the express grant by the Company to the Agent of a security interest in such commercial tort claim (and the proceeds thereof). In the event that such notice does not include such grant of a security interest, the sending thereof by the Company to the Agent shall be deemed to constitute such grant to the Agent. (g) The Company shall take any other actions reasonably requested by the Agent from time to time to cause the attachment, perfection and first priority of, and the ability of the Agent to enforce, the security interest of the Agent in any and all of the Collateral, including, without limitation, (i) executing, delivering and, where appropriate, filing financing statements and amendments relating thereto under the UCC or other applicable law, to the extent, if any, that the Company's signature thereon is required therefor, (ii) causing the Agent's name to be noted as secured party on any certificate of title for a titled good if such notation is a condition to attachment, perfection or priority of, or ability of the Agent to enforce, the security interest of the Agent in such Collateral, (iii) complying with any provision of any statute, regulation or treaty of the United States as to any Collateral if compliance with such provision is a condition to attachment, perfection or priority of, or ability of the Agent to enforce, the security interest of the Agent in such Collateral, (iv) obtaining the consents and approvals of any governmental authority or third party, including, without limitation, any consent of any licensor, lessor or other person obligated on Collateral, and taking all actions required by any earlier versions of the UCC or by other law, as applicable in any relevant jurisdiction, provided, however, that: (i) the Company shall not be required to expend any funds to obtain such an approval or consent from a governmental authority or third party (except for UCC filing and other recording fees and filing fees) and; (ii) the foregoing shall not be deemed to require the Company to obtain landlord's waivers except as otherwise required under Section 7.1A (viii) hereof. (c) The following is hereby added as Section 6.9 of the Financing Agreement: 6.9 Following the occurrence and during the continuance of any Event of Default and to the extent otherwise permitted pursuant to this Agreement, the Company hereby irrevocably constitutes and appoints the Agent as the Company's true and lawful attorney, with full power of substitution, to convert the Collateral into cash at the sole risk, cost, and expense of the Company, but for the benefit of the Agent and the Lenders. The rights and powers granted the Agent by the within appointment include but are not limited to the right and power to: (i) Prosecute, defend, compromise, or release any action relating to the Collateral. (ii) Sign change of address forms to change the address to which the Company's mail is to be sent to such address as the Agent shall designate; receive and open the Company's mail; remove any cash or other proceeds of Collateral therefrom and turn over the balance of such mail either to the Company or to any trustee in bankruptcy, receiver, assignee for the benefit of creditors of the Company, or other legal representative of the Company whom the Agent determines to be the appropriate person to whom to so turn over such mail. 12 (iii) Endorse the name of the Company in favor of the Agent upon any and all checks, drafts, notes, acceptances, or other items or instruments; sign and endorse the name of the Company on, and receive as secured party, any of the Collateral, any invoices, schedules of Collateral, freight or express receipts, or bills of lading, storage receipts, warehouse receipts, or other documents of title respectively relating to the Collateral. (iv) Sign the name of the Company on any notice to such Company's account debtors or verification of the Accounts; sign Company's name on any proof of claim in bankruptcy against account debtors, and on notices of lien, claims of mechanic's liens, or assignments or releases of mechanic's liens securing the Accounts. (v) Take all such action as may be necessary to obtain the payment of any letter of credit and/or banker's acceptance of which the Company is a beneficiary. (vi) Repair, manufacture, assemble, complete, package, deliver, alter or supply goods, if any, necessary to fulfill in whole or in part the purchase order of any customer of the Company . (vii)Use, license or transfer any or all general intangibles of the Company. 5. Amendments to Section 7 (a) Section 7 of the Financing Agreement is hereby amended to add the following 7.1A thereto: 7.1A As an inducement to each of the Lenders and the Agent to enter into the Sixth Amendment, the Company hereby confirms that all representations and warranties made under Section 7 of the Financing Agreement continue to be true, accurate and complete as of the date of the Sixth Amendment except as indicated on the updated schedules attached hereto as Updated Schedule 1 (Existing Liens) and Updated Schedule 2 (Collateral Locations, Chief Executive Office and Trade Names). In addition, the Company makes the following representations, warranties and covenants: (i) The Company shall pay each Obligation when due (or on demand if payable on demand), and shall promptly, punctually and faithfully perform each of its other Obligations and liabilities under this Financing Agreement and the other Loan Documents. (ii) The Company shall not change its state of incorporation or its taxpayer identification number without providing at least thirty (30) days prior written notice thereof to the Agent. (iii)The Company is duly organized, validly existing, and in good standing under the laws of the jurisdiction in which it is organized and in each jurisdiction where foreign qualification is required for it to be qualified to do business, except for any violations that would not individually or in the aggregate, result in a Material Adverse Effect. The Company is duly authorized to enter into, and perform its obligations under, this Agreement and the agreements, instruments and documents executed in conjunction herewith. The execution, delivery and performance by the Company of this Agreement will not violate the Company's charter, partnership agreement or operating agreement, any law or any provision thereof, except for any violations that would not individually or in the aggregate, result in a Material Adverse Effect. 13 (iv) Updated Schedule 2 annexed hereto contains a listing of all names in which the Company ever conducted its business and all entities and/or Persons with whom the Company ever consolidated or merged, or from whom the Company ever acquired in a single transaction or series of related transactions substantially all of such entity or Person's assets or stock. (v) The Company will not change its name or conduct its business under any name not listed on Updated Schedule 2 except upon not less than twenty-one (21) days prior written notice to the Agent and compliance with all the other provisions of this Financing Agreement. (vi) The Company has and will maintain sufficient infrastructure to conduct its business as presently conducted and contemplated to be conducted as described in its business plan; and owns and possesses or has a right to use all assets necessary for the conduct of its business (including, but not limited to, agreements concerning the use of property of any third person necessary for the conduct of its business). (vii)Except for Eligible In-Transit Inventory in the possession of a consolidator, freight forwarder or customs broker, no tangible personal property of the Company is in the care or custody of any third party or stored under an entrustment or bailment arrangement with a third party and none shall hereafter be placed under such care, custody, storage or entrustment unless a bailee agreement reasonably satisfactory to Agent is executed and delivered by such third party and in respect to Inventory which is in transit to the Company, such Inventory constitutes Eligible In-Transit Inventory. (viii) For each location in the State of Washington, Virginia or Pennsylvania, the Company will use reasonable efforts to supply the Agent with a landlord's waiver or the Agent shall establish an Availability Reserve for such location equal to two (2) months rent for each retail store location unless and until such time as a satisfactory landlord's waiver in respect to such location is delivered to the Agent. (ix) The Company does not have any Indebtedness with the exception of Permitted Indebtedness. (x) Updated Schedule 2 annexed hereto contains a schedule of all leases for any location which any Company operates a retail store (including, but not limited to temporary or seasonal store locations) or warehouse, distribution center or manufacturing facility, identifying which type of facility is located on each site and whether such site is the location of a retail store which has been closed or which the Company intends to close during the remainder of its 2003 fiscal year ended January 31, 2004. Except as set forth in Updated Schedule 2, and in respect to Closed Stores, each of such leases is in full force and effect, and the Company is not in default or violation of any such lease (except with respect to any non-payment of rent in connection with a good faith dispute) and the Company has not received any notice of termination, default or cancellation of any such lease. (xi) The Company is in full compliance with all applicable provisions and ERISA or otherwise applicable law in respect to any and all retirement or employee benefit plans maintained by it and has filed all reports required to be filed in respect to or under ERISA or other applicable law. 14 (xii)Except as describe in Updated Schedule 3 annexed hereto, there is not presently pending or to the knowledge of the Company, threatened by or against the Company any litigation which would reasonably expect to have a Material Adverse Effect upon the Company's financial condition or ability to conduct its business or the Collateral. (xiii) Updated Schedule 2 hereto correctly and completely sets forth the Company's Chief Executive's Office, all of the Company's Collateral locations and all trade names of the Company. (xiv)Updated Schedule 1 hereto summarizes all existing liens outstanding against the Company and or any of its affiliates in any applicable jurisdictions; (xv) The Company is in compliance all applicable laws, other than any laws the noncompliance with which would not reasonably expected to have a Material Adverse Effect. The Company has not received any notice of violation of any applicable law, which violation has not been cured or otherwise remedied, and which violations would have a Material Adverse Effect. (xvi)The Company, to the Company's Knowledge, has not been and is not presently party to any collective bargaining agreement or other labor contract. There is not presently pending and, to the Company's knowledge, there has not been threatened, any (i) strike, slowdown, picketing, work stoppage or employee grievance process; (ii) any proceeding against or effecting the Company relating to the alleged violation of any law applicable to labor relations or the National Labor Relations Board, the Equal Employment Opportunity Commission or any comparable government body, which, if determined adversely to the Company would have a Material Adverse Effect or (iii) any lockout of any employees by the Company or any application for certification of collective bargaining agent. (xvii) Except as may relate to the audit currently being conducted by the Internal Revenue Service or as disclosed on Schedule 4 hereto, to the Company's Knowledge, the Company has (i) paid, as they have become due and payable, all taxes and employment contributions and other charges of any kind or nature levied or which could be claimed against the Company or the Collateral by any Person whose claim could result in an encumbrance upon any assets of the Company or by any governmental authority except for such taxes, contributions, and other charges (x) the failure to pay which would not reasonably be expected to have a Material Adverse Effect, or (y) which are being contested in good faith through appropriate proceedings; (ii) properly withheld or collected and properly paid over to the relevant governmental authority withholding any payroll or other tax from employees, or other funds received in trust from a third party including sales taxes except for such taxes or other funds the failure to withhold, collect or pay over which would not reasonably be expected to have a Material Adverse Effect; (iii) timely made all contributions or other payments as may be required pursuant to any pension or other employee benefit plan established by the Company except for such contributions and payments the failure to timely make which would not reasonably be expected to have a Material Adverse Effect, (iv) timely filed all tax and other returns or other reports with each governmental authority with whom the Company is obligated to file such reports except for such returns or reports the failure to file which would not reasonably be expected to have a Material Adverse Effect, and (v) has not to its Knowledge received any notice from a state, federal or local taxing authority that it has assessed any additional taxes or notifying the Company of a failure to pay taxes or file any tax returns in respect to any prior period or otherwise alleging that the Company may have additional tax liability except for such taxes or tax returns the failure to pay or file as applicable, which would not reasonably be expected to have a Material Adverse Effect. For purposes of this subsection, Material Adverse Effect shall refer to a negative impact of at least One Hundred Thousand Dollars ($100,000). 15 (xviii) To its Knowledge, the Company has never been legally responsible for any release or reported release of any hazardous material or received notification of any release or reported release of any hazardous material from any site occupied or operated by the Company. (xix)All financial reports and other financial or Collateral information provided by the Company to the Agent and Lenders in conjunction with the Obligations are true, accurate and complete in all material respects and all financial statements provided by the Company to the Agents and Lenders were prepared in accordance with GAAP consistently applied. (xx) Annexed hereto as Schedule 5 is a schedule of all present Depository Accounts maintained by the Company, which Schedule includes, with respect to each Depository Account (i) the name and address of the depository; (ii) the account number(s) of the account(s) maintained with such depository; and (iii) a contact person at such depository. The Company will provide the Agent with at least ten (10) business days prior notice prior to its establishment of any additional Depository Accounts. (xxi)All funds in any Depository Account and all proceeds of Credit Card Receivables shall be deposited within two (2) Business Days of their receipt into the Company's depository account at Bank of America (the "Blocked Account") listed on Schedule 5 hereto. The Company acknowledges that the contents of each Depository Account and of the Blocked Account constitute Collateral and proceeds of Collateral. The Company further acknowledges that Bank of America, the Company, and the Agent are parties to a Blocked Account Agreement dated as of March, 2000 pursuant to which, inter alia, Bank of America acknowledged that the Agent has been granted a lien on all funds deposited in the Blocked Account, and agreed that upon notice from the Agent, it shall commence to wire transfer funds deposited in the Blocked Account as directed by the Agent. The Company confirms that such Blocked Account Agreement remains in full force and effect, constitutes a legally valid, binding and enforceable obligation of the Company and Bank of America and that the rights granted to the Agent thereunder are intended to be for the benefit of both the Tranche A Lenders and the Tranche B Lender. The foregoing provisions regarding Depository Accounts and Blocked Accounts shall be subject to Section 3.4 of the Financing Agreement which permits the Company to enforce, collect and receive all amounts owing on Accounts and manage and direct its Depository Accounts unless and until Triggering Availability is less than $10,000,000 or as otherwise provided therein. (b) The provisions of the second sentence of Section 7.2 regarding the Agent's right to inspect the Collateral and any and all records pertaining to the collateral or otherwise maintained by the Company is hereby amended as follows: The Company agrees that the Agent and any Lender, and their respective agent, may enter upon the Company's premises at any time upon reasonable prior notice to the Company and inspect the Company's books, records or the Collateral provided, however, that the Company shall only be required to reimburse the Agent's and/or such Lender's Out-of-Pocket Expenses related to such inspection twice in a twelve (12) month period except that (x) at any time Triggering Availability is less than ($20,000,000) and at all times thereafter until such time as the Company maintains Triggering 16 Availability of Twenty Million Dollars ($20,000,000) or more for a period of ninety (90) consecutive days or (y) following the occurrence and during the continuance of an Event of Default, the Agent and the Lenders shall not be limited in the number of times Agent or Lender or their respective agents may enter upon the Company's premises and the Company shall be obligated to reimburse the Agent and/or Lenders for all Out-of-Pocket Expenses related to all such inspections without limitation. (c) Notwithstanding anything in the existing text of Section 7.3, at all times any Obligations are outstanding, the Company shall provide each Lender with all reports required to be furnished under Section 7.3 of the Financing Agreement and the Agent and each Lender with a borrowing base report on the dates listed on Schedule 6 hereto for the Company's 2003 fiscal year, (which schedule shall be revised by the Company and the Agent for subsequent fiscal years) regardless of the level of Triggering Availability which may exist and at any time Triggering Availability is less than Ten Million Dollars ($10,000,000) or following the occurrence and during the continuance of any Event of Default, the Company shall provide such report on a weekly basis. In addition to the financial information required to be provided under Sections 7.3 and 7.8 of the Financing Agreement, the Company agrees to provide the Agent and each Lender with the additional reports listed on Schedule 7 hereto (which reports shall be provided monthly on or before the twentieth (20th) day of the next month unless indicated to the contrary). (d) The following additional paragraph is added to Section 7.3 of the Financing Agreement. In addition to the preceding reports, the Company shall promptly provide the Agent, with a copy to each Lender, with written notice of, the occurrence of any of the following, which written notice shall set forth as to the facts and circumstances in respect to which such notice is being given, with reasonable specificity: (i) any change in its board of directors, or any of its chief executive officers, president or chief financial officer; (ii) the completion of any physical count encompassing at least twenty-five percent (25%) of its Inventory, together with a copy of the results thereof; (iii) any failure by the Company to pay rent (other than in connection with a good faith dispute) at more than five (5) retail store locations at the same time (except for the Closed Stores or the Piper Distribution Center property) continuing unremedied for more than thirty (30) days; (iv) the occurrence of any Default (within five (5) Business Days after the Company has Knowledge of such occurrence ) (provided, however, that failure to give any such notice shall not, by itself, constitute an Event of Default if the Default is cured at or within ten (10) business days following the giving of such notice); (v) any change in the Company's independent accountant; (vi) any litigation which would be reasonably expected to have a Material Adverse Effect on the Company; and (vii) copies of any press releases and all annual, periodic and current reports it files with the Securities and Exchange Commission (d) Intentionally Omitted. (e) In addition to those actions specified in Section 7.9 of the Financing Agreement, the Company agrees that until termination of the Financing Agreement and payment and satisfaction of all Obligations due hereunder in full, the Company shall not, unless the Agent and Tranche B Lender provides their prior written consent (which will not be unreasonably withheld), do any of the following: (i) So long as any Tranche B Obligations are outstanding, execute any lease or commit to open or become legally obligated to open any additional retail store locations unless (i) such lease or commitment is consistent with a business plan submitted to and deemed reasonable by Agent and each Lender; (ii) if such store is in Washington State, the Company shall use reasonable efforts to obtain a landlord's waiver in respect to the subject store; and (iii) without the prior written consent of Agent and the Tranche B 17 Lenders, not to be unreasonably withheld, such commitment will not result in the opening of more than eight (8) stores during the Company's fiscal year 2003 ended January 31, 2004 and twenty-five (25) stores during fiscal year 2004 ended January 31, 2005, and a number of stores to be determined by Agent, in its discretion, after consultation with the Company and each Lender, for any subsequent fiscal year during which any Obligations are outstanding, provided, however, that, if the Company provides the Agent with a business plan for fiscal year 2004, providing for the opening of more than twenty-five (25) stores in such fiscal year and the Agent, in its discretion after consultation with the Tranche B Lender, deems such plan reasonable, the Company shall be permitted to open up the number of stores contemplated by such business plan without having to obtain Agent's or the Tranche B Lender's prior written consent. Anything to the contrary notwithstanding, the provisions of this subsection (i) shall terminate at such time as there are no Tranche B Obligations outstanding. (ii) Amend, modify or otherwise alter materially the terms of any lease in a manner which, individually or in the aggregate, would have a Material Adverse Effect on the Company. (iii) So long as any Tranche B Obligations are outstanding: commit to close any retail store locations or the Piper Road Distribution Center Property except that the Company may close up to twenty-four (24) of its permanent retail stores in place at the beginning of fiscal 2003 (including the Closed Stores) or 2004 during each of such fiscal years without the consent of the Agent and Tranche B Lender provided that there does not exist a Default or Event of Default at the time of such closure and provided further, however, that if the Company provides the Agent with a business plan for fiscal 2004 or any subsequent fiscal year providing for the closing of more than twenty-four (24) stores in such fiscal year and the Agent, in its discretion, after consultation with the Tranche B Lender, deems such plan reasonable, the Company shall be permitted to close the number of stores contemplated by such business plan without having to obtain Agent's or Tranche B Lender's prior written consent. In the event that the Company intends to close more than ten (10) stores at the same time, the Company shall engage a professional liquidator unless the Agent and the Tranche B Lender, in their reasonable discretion, consent to permit the Company to conduct such closings. (f) Section 7.13 of the Financing Agreement is hereby amended so as to require the Company to provide the Agent with appraisals of the Net Orderly Liquidation Value of Inventory twice each year at such time as the Agent may reasonably require at the Company's expense, provided, however, that if, (A) the Company fails to maintain Triggering Availability of at least Twenty Million Dollars ($20,000,000) for a period of ninety (90) consecutive days, Agent, in its discretion, may require that up to an additional two (2) gross recovery update appraisals per year be conducted at the Company's expense and (B) in the event that the Company closes more than twenty-four (24) stores in any fiscal year, the Agent may in its discretion, require one (1) additional gross recovery update appraisal, conducted at the Company's expense. (g) The following additional financial covenants are hereby added to the Financing Agreement: 7.15 So long as any Tranche B Obligations are outstanding, the Company shall either (a) have a Triggering Availability of at least Ten Million Dollars ($10,000,000) on the last three (3) days of each month commencing on May 3, 2003 or (b) not permit or suffer its EBITDA tested as of the last day of each fiscal month, commencing on May 3, 2003,, on a cumulative basis, to be less than the Minimum EBITDA listed in the following chart for the applicable period specified on such chart, with the first measurement to occur as of May 3, 2003 for the fiscal quarter then ended, and each subsequent measurement shall pertain to the period beginning on February 2, 2003 and ending on the date of measurement listed on the chart below. 18 - ------------------------------- -------------------------- Period Ending Minimum EBITDA - ------------------------------- -------------------------- - ------------------------------- -------------------------- May 3, 2003 $ (1,870,000) - ------------------------------- -------------------------- - ------------------------------- -------------------------- May 31, 2003 $ (1,771,000) - ------------------------------- -------------------------- - ------------------------------- -------------------------- July 5, 2003 $ (323,760) - ------------------------------- -------------------------- - ------------------------------- -------------------------- August 2, 2003 $ 136,000 - ------------------------------- -------------------------- - ------------------------------- -------------------------- August 30, 2003 $ 2,165,000 - ------------------------------- -------------------------- - ------------------------------- -------------------------- October 4, 2003 $ 2,032,000 - ------------------------------- -------------------------- - ------------------------------- -------------------------- November 1, 2003 $ 3,452,000 - ------------------------------- -------------------------- - ------------------------------- -------------------------- November 29, 2003 $ 5,167,000 - ------------------------------- -------------------------- - ------------------------------- -------------------------- January 3, 2004 $ 13,201,000 - ------------------------------- -------------------------- - ------------------------------- -------------------------- January 31, 2004 $ 10,971,000 - ------------------------------- -------------------------- The required Minimum EBITDA levels for each fiscal month from and after February 1, 2004 shall be measured on a rolling 12-month basis and shall be established based on eighty percent (80%) of the Company's cumulative projected EBITDA levels as shown on the Company's business plan for fiscal year 2004, provided that the Agent and Tranche B Lender has deemed such business plan reasonable in their discretion, or in the absence of a business plan deemed reasonable by the Agent and Tranche B Lender, by the Agent, in the Agent's discretion, after consultation with the Company and the Lenders, based on such financial information as may be in the Agent's possession, subject to readjustment in the Agent's discretion, after consultation with the Company and each Lender, upon the Company's subsequent delivery of a business plan which is deemed reasonably acceptable by the Agent and Tranche B Lender. Anything to the contrary notwithstanding, the provisions of this Section 7.15 shall terminate at such time as there are no Tranche B Obligations outstanding. 7.16 During the period from December 22 through January 5 of each year so long as any Tranche B Obligations are outstanding, there shall be no outstanding balance of the Revolving Loans (exclusive of Letters of Credit) and the Stated Amount of Outstanding Letters of Credit shall not exceed $12,200,000. 7.17 The Company shall not incur more than Five Million Dollars ($5,000,000) in aggregate Capital Expenditures on a consolidated basis during its fiscal year ended January 31, 2004 without the prior written consent of the Agent and Tranche B Lender. In the event that the Tranche B Maturity Date is extended beyond April 10, 2004, as provided in Section 11.1(a) hereof, the Company shall not incur aggregate Capital Expenditures in excess of 115% of the Capital Expenditures shown on a business plan for Company's 2004 fiscal year (or any subsequent fiscal year), which is deemed reasonable by the Agent and the Tranche B Lender in their discretion. In the event that the Company has not delivered an updated, preliminary business plan approved by management (subject to approval by the Company's Board of Directors) deemed reasonably acceptable by the Agent and Tranche B Lender by January 31 of the prior fiscal year, the permissible level of Capital Expenditures for the succeeding fiscal year shall be established by the Agent, in its discretion, after consultation with the Company and the Tranche B Lender, based on such financial information as is then in the Agent's possession, subject to readjustment, in the Agent's discretion, upon the Company's subsequent delivery of a business plan which is reasonably acceptable to the Agent and Tranche B Lender. Upon establishment of such new level of Capital Expenditures for such subsequent fiscal year, such new levels shall be deemed to be incorporated into this Section 7.17. 19 7.18 The Company shall at all times keep proper books of account, in which full, true and accurate entries shall be made of the Company's transactions, all in accordance with GAAP (if applicable), applied consistently with prior periods to, thoroughly reflect the financial condition of the Company at the close of, and as a result of operations for, the periods in question, the Company shall, upon reasonable prior notice during normal business hours, accord the Agent and each Lender and the respective representatives with access from time to time as the Agent, and such Lenders and their representatives may require or request to examine, inspect, and copy and make extracts from any and all of the Company's books, records, electronically stored data, papers and files. 6. Amendments to Section 8. (a) The Company hereby confirms that it has authorized the Agent to charge the Loan Account or other sums; credit or other amount due to the Company for any or all amounts due hereunder to the Tranche B Lender (in addition to amounts due to the Tranche A Lender) as such payments become due and payable and further confirms that the provisions of Section 8.11 hereof are intended to, and shall, apply to the Tranche B Obligations. (b) Section 8 of the Financing Agreement is hereby amended by adding the following new sections after section 8.11 thereof: 8.12 The unpaid principal balance of each of the Tranche B Loans shall bear interest, until repaid, at a rate per annum equal to Fourteen and one-half percent (14.5%) per annum (based upon a 360-day year and actual days elapsed), which shall be due and payable on the first day of each month in arrears commencing on May 1, 2003. Following the occurrence and during the continuance of any Event of Default (and whether or not Agent exercises any of the rights or remedies provided hereunder on account thereof), the Tranche B Loan shall bear interest at a rate of sixteen and one-half percent (16.5%) per annum and all such interest shall be payable on demand. 8.13 In addition to any other fee or expense to be paid by the Company on account of the Tranche B Loans, the Company shall pay the Tranche B Lender directly, the "Tranche B Commitment Fee" and the "Tranche B Anniversary Fee" as and when provided in the Tranche B Fee Letter. 8.14 In the event that an Early Termination Date occurs, or the Tranche B Loan is otherwise repaid in full for any reason, prior to January 31, 2004, the Company shall pay the Agent for the benefit of the Tranche B Lender, or to the Tranche B Lender directly, the "Tranche B Early Termination Fee" payable on the date of such repayment or termination, determined as follows: The Tranche B Early Termination Fee shall equal the difference between (A) One Million One Hundred Thousand Dollars ($1,100,000) and (B) the sum of all Tranche B Interest, Tranche B Commitment Fees and Tranche B Anniversary Fees actually paid in cash by the Company and received by the Tranche B Lender, but in no event less than zero dollars ($0). 8.15 The full unpaid balance of Tranche B Term Loan I shall be due and payable on the first to occur of the Tranche B Maturity Date or an Early Termination Date, provided, however, that the Company shall not pay the balance of Tranche B Term Loan I on the Tranche B Maturity Date if an Event of Default hereunder then exists or if such payment would create an Event of Default hereunder and provided further, however, that, notwithstanding the foregoing, the failure of the Company to pay the full outstanding balance of Tranche B Loan I on the Tranche B Maturity Date shall constitute an Event of Default hereunder. The principal balance of the Tranche B Term Loan II shall be due and payable out of the net proceeds received by the Company from a sale or refinancing of the Tranche B Senior Collateral (including, but not limited to, a sale/leaseback thereof) as provided 20 below in this Section 8.15; provided, however, that in the event that the full unpaid balance of Tranche B Term Note II has not been paid by October 31, 2003, the Company shall make the following payments in respect to principal due thereunder: on November 1, 2003, such amount as is necessary to reduce the outstanding principal balance of Tranche B Term Loan II to seven hundred thousand dollars ($700,000) and on the first day of December, 2003 and each month thereafter until the entire outstanding balance of Tranche B Loan II has been paid, the lesser of (a) One Hundred Thousand Dollars ($100,000) or (b) the outstanding principal balance of the Tranche B Loan II. Any principal or interest in respect to the Tranche B Loan II which has not been paid by the Tranche B Maturity Date shall be due and payable on such date unless such date is extended pursuant to Section 8.13 hereof in which event the Company shall continue to make principal payments of One Hundred Thousand Dollars ($100,000) per month until the Tranche B Loan II is paid in full. The Agent and each of the Lenders hereby agree that items of Tranche B Senior Collateral may be sold, refinanced or included in a sale/leaseback transaction; provided that: (i) in respect to all Tranche B Senior Collateral other than the Piper Tranche B Senior Collateral the net proceeds of such transactions shall be paid to the Agent for application against the Tranche B Loan II until the outstanding balance thereof has been paid and, thereafter, shall be applied against the Tranche A Loans and (ii) in respect to the Piper Tranche B Senior Collateral, the net proceeds are distributed as follows: (A) if such net proceeds are less than Two Million Dollars ($2,000,000.00), the first One Million Dollars ($1,000,000.00) of such net proceeds shall be paid to Agent for application in reduction of Tranche B Loan II; (B) if such net proceeds are greater than Two Million Dollars ($2,000,000.00) but less than Three Million Dollars ($3,000,000.00), the first Five Hundred Thousand Dollars ($500,000.00) of such net proceeds shall be paid to Agent for application in reduction of Tranche B Term Loan II; and (C) if such net proceeds are greater than Three Million Dollars ($3,000,000.00) the Company may retain the full amount thereof. 7. Amendments to Section 10. (a) 7.1.(e) is hereby amended by adding the following proviso: provided, however, that the Company shall have only ten (10) days to remedy a default related to its failure to provide a Borrowing Base Certificate on the date when due hereunder and, provided further, however that the Company shall not have any cure period in respect to any misrepresentation which is material. (b) Section 10.1 of the Loan Agreement is hereby amended by adding the following additional Events of Default after subparagraph (i) thereof: (j) material breach by the Company of its leases for more than five (5) retail locations at the same time (exclusive of leases for Closed Stores) or the Piper Distribution Center Property such that such lease(s) could be terminated by the landlord therefor. (k) The entry of a final, nonappealable order by a court of competent jurisdiction allowing any Person to attach, by trustee, mesne, or other process, any of the Company's funds or assets, the Company in excess of $375,000. (l) The entry of any final judgment against the Company in excess of $375,000, which judgment is not satisfied (if a money judgment) or appealed from (with execution or similar process stayed) within the applicable appeals period or not covered in full by insurance. 21 (m) The entry of any order or the imposition of any other process having the force of law, the effect of which is to restrain in any material way the conduct by the Company of its business in the ordinary course, which is not removed within thirty (30) days of its issuance. (n) The conviction of, or entry of a final, non-appealable order against the Company, under any federal, state, municipal, and other civil or criminal statute, rule, regulation, order or other legal requirement in a proceeding instituted by a governmental unit or agency where the relief, penalties, or remedies include the forfeiture of any property of the Company and/or the imposition of any stay or other order, the effect of which could be to restrain in any material way the conduct by the Company of its business in the ordinary course or have another Material Adverse Effect. (o) Any challenge by or on behalf of the Company or any guarantor of the Obligation to the validity of any Loan Document or the applicability or enforceability of any Loan Document strictly in accordance with the subject Loan Document's terms or which seeks to void, avoid, limit, or otherwise adversely affect any security interest created by or in any Loan Document or any payment made pursuant thereto. (p) Any determination by any court or any other judicial or government authority that any Loan Document is not enforceable strictly in accordance with the subject Loan Document's terms or which voids, avoids, limits, or otherwise adversely affects any security interest created by any Loan Document or any payment made pursuant thereto. (q) So long as any Tranche B Obligations are outstanding, any Change of Control unless, within sixty (60) days of such Change of Control either (i) Tranche B Lender shall have consented thereto (which consent shall not be unreasonably withheld) in writing or (ii) the Tranche B Obligations shall have been paid in full (and the Tranche B Lender hereby agrees that any such payment may be made without any prepayment penalty). (r) The Company shall fail to observe or perform any condition precedent or subsequent to the Sixth Amendment or any covenant contained therein or any representation or warranty made thereunder shall fail to be true, accurate or complete as of the date when made or any covenant made thereunder shall be breached, unless such representation or warranty is rendered true, accurate and complete or the breach of such covenant is cured within twenty-one (21) days of notice from the Agent specifying such failure or breach . (b) The Company, Agent and each Lender agree that the exercise by the Agent of the rights and remedies provided under Sections 10.2 and 10.3 of the Financing Agreement shall be subject to the provisions of the Agency Agreement so long as of the Tranche B Obligations remain outstanding. (c) The following is hereby inserted as Section 10.3(d) of the Financing Agreement: (d) Any and all deposits or other sums at any time credited by or due to the Company from the Agent or any Lender or any participant (a "Participant") in the Tranche A Loans or Tranche B Loans contemplated hereby or from any Affiliate of any Agent or any Lender or any Participant and any cash, securities, instruments or other property of the Company in the possession of any Agent or any Lender, any Participant or any such Affiliate, whether for safekeeping or otherwise (regardless of the reason such Person had received the same) shall at all times constitute security for all Obligations and for any and all other obligations of the Company to any Agent or any Lender or any Participant or any such Affiliate and may be applied or set off against the Obligations at any time, whether or not such are then due and whether or not other collateral is then available to the Agent, Lender, Participant or Affiliate. 22 8. Amendments to Section 11. (a) Section 11.1 of the Financing Agreement is hereby amended to read as follows: 11.1 The Tranche A Loans shall be due and payable on the Tranche A Maturity Date. Subject to the proviso to the first sentence of Section 8.15 hereof, the Tranche B Loans shall be due and payable on the Tranche B Maturity Date; provided, however, that, at the written request of the Company received by the Tranche B Lender and the Agent on or before March 1, 2004, the Tranche B Maturity Date in respect to Tranche B Loan I and the unamortized portion of Tranche B Loan II shall be extended for an additional term of twelve (12) months (i.e., through April 9, 2005), so long as the Company is in compliance with all of the following conditions: (i) For the Company's 2003 Fiscal Year ended January 31, 2004, the Company shall have achieved a minimum EBITDA of Ten Million Three Hundred Thousand Dollars ($10,300,000), as audited by the Company's outside accountants; and (ii) As of the last day of fiscal year 2003, the Company shall have Eligible Inventory with a value determined at the lower of cost or market on a first-in, first-out basis of at least Forty Million Dollars ($40,000,000). (iii) On or before the effective date of such notice, the Company shall have furnished the Agent and Tranche B Lender with a preliminary business plan for 2004, approved by the Company's management (subject to approval by the Company's Board of Directors) which the Tranche B Lender has deemed reasonably acceptable, in its discretion. In the event that the Tranche B Maturity Date is extended, on or before April 10, 2004, the Company shall pay the Tranche B Lender the Tranche B Anniversary Fee due on such date pursuant to the Tranche B Fee Letter. (b) Section 11.2 of the Loan Agreement is hereby amended to clarify that the provisions thereof concerning the automatic continuation of the Financing Agreement and the provisions of the fourth and fifth sentences thereof concerning the circumstances in which the Early Termination Fee is or is not due only apply to the Tranche A Early Termination Fee and not to the Tranche B Early Termination Fee. (c) The sixth sentence of Section 11.2 is hereby deleted. 9. Amendments to Section 12. (a) Section 12.6 of the Loan Agreement is hereby amended by adding the following additional notice to parties as subsection (d) thereof: To Tranche B Lender: Mr. Lawrence Klaff, Managing Director Gordon Brothers Retail Funding, LLC Gordon Brothers Group 40 Broad Street Boston, MA 02109 Telephone: (617) 422-7886 Fax: (617) 210-7141 23 Copies of any such notices should also be provided to: Steven B. Levine, Esq. Brown Rudnick Berlack Israels LLP One Financial Center Boston, MA 02111 Telephone: (617) 856-8587 Fax: (617) 856-8201 All notices to Agent or the Tranche A Lender shall henceforth be sent to the following addresses: The CIT Group/Business Credit, Inc. 300 South Grand Avenue, Third Floor Los Angeles, CA 90071 Attention: Credit Manager/Retail Finance Group Fax: (213) 613-2599 With a copy to: Farhad Bahar, Esq. Buchalter Nemer Fields & Younger 601 South Figueroa Street, Suite 2400 Los Angeles, CA 90017-5704 Telephone: (213) 891-0700 Fax: (213) 630-5703 (b) Section 12.7 of the Loan Agreement is hereby amended to read as follows: The validity, interpretation and enforcement of this Financing Agreement shall be governed by and construed under the laws of the State of California; provided, however, that the Tranche B Notes and the provisions setting forth the Tranche B Lenders and the Company's and Tranche B's rights and obligations in respect to principal, interest and fees on the Tranche B Loans shall be governed and construed, as between Company and Tranche B Lender only, under the laws of the Commonwealth of Massachusetts. Notwithstanding the above, all matters and provisions relating to the Collateral and all matters and provisions as between Agent and Tranche A Lenders or between Agent and/or Tranche A Lenders, on the one hand, and Company or Tranche B Lenders, on the other hand, shall be governed by and construed under the laws of the State of California. (c) Section 12.8 of the Financing Agreement shall be deemed deleted so long as the Agency Agreement is in effect. (d) The following new Section 12.9 is hereby added to the Financing Agreement 12.9 Agent's or Lenders' Discretion. (a) Each reference in the Financing Agreement or other Loan Documents to the exercise of discretion or the like by Agent or any Lender shall be to Agent's or such Lender's exercise of its commercially reasonable judgment, in good faith, based upon Agent's or such Lender's consideration of any such factor as Agent's or such Lender, taking into account information of which Agent or such Lender then has actual knowledge, believes: 24 1. Will or reasonably could be expected to materially affect: the value of the Collateral, the enforceability of the Agent's and Lender's security and collateral interests therein, or the amount which the Agent or Lenders would likely realize therefrom (taking into account delays which may possibly be encountered in the Agent's or Lender's realizing upon the Collateral and likely Out-Of-Pocket Expenses). 2. Indicates that any report or financial information delivered to the Agent or Lender by or on behalf of the Company is incomplete, inaccurate, or misleading in any material manner or was not prepared in accordance with the requirements of this Agreement. 3. Suggests a material increase in the likelihood that the Company will become the subject of a bankruptcy or insolvency proceeding. 4. Constitute a material Default. (b) In the exercise of such judgment, Agent or any Lender also may take into account any of the following factors: 5. Those included in, or tested by, the definitions of "Availability" and "Net Orderly Liquidation Value". 6. The current financial and business climate of the industry in which the Company competes (having regard for the Company's positions in that industry). 7. General macroeconomic conditions which have a material effect on the Company's cost structure. 8. Material changes in or to the mix of the Company' Inventory. 9. Seasonality with respect to the Company's Inventory and patterns of retail sales. 10. Such other factors as either Agent or any Lender determine, in good faith, are likely to have a material bearing on credit risks associated with the providing of loans and financial accommodations to the Company. 10. Amendments to Section 13. (a) The provisions of Sections 13.1, 13.2 and 13.6 shall apply only to Tranche A Lenders and Tranche A Loans., (b) In Section 13.1, the provision regarding the circumstances in which the Agent must obtain the Company's prior consent to admission of new Lenders in the Financing Agreement shall only apply to the admission of Tranche A Lenders and not to the addition of assignees or participants in the Tranche B Loans. (c) The provisions of Section 13.4 thereof shall only apply to the distribution of interest and fees due to the Tranche A Lenders amongst the Tranche A Lenders and the Agent shall promptly remit any interest and fees it receives in respect to the Tranche B Loans to the Tranche B Lenders pursuant to the Agency Agreement. (d) The following additional Section 13.10 is hereby added to the Financing Agreement: Except as provided in this Section 13.10, the Tranche B Lender shall obtain the prior written consent of the Company and the Agent to the assignment of all or any portion of the Tranche B Loans, which consent, in either instance, shall not be unreasonably withheld or delayed. The foregoing shall not prohibit or restrict the following transfers of all or any portion of the Tranche B Loans or interests therein, which may be made without prior notice to or the consent of the Agent or the Company: 25 (i) Assignments of or transfers of Participation Interests (defined below) in all or any portion of the Tranche B Loans among affiliates of GB Retail Funding, LLC ("GB"), which affiliates shall include the following: (i) all entities or persons under the direct or indirect control of GB, (ii) all entities which directly or indirectly own at least ten percent (10%) of the equity interests in GB, ("Parent Entities"), (iii) all entities of which a Parent Entity directly or indirectly owns twenty percent (20%) or more of the outstanding equity (including, but not limited to, GB Palladin Fundings, LLC), and (iv) Fortress Drawbridge Special Opportunities Fund ("Fortress") and funds managed by or affiliated with the High Bridge fund group ("High Bridge") and any other "fund partner" of GB's or another affiliate which regularly invests in junior secured loans to retailers arranged by GB or such other affiliate. (The Company and Agent hereby acknowledge that GB intends to sell participation interests in the Tranche B Loans to Fortress and High Bridge promptly after the effective date of the Sixth Amendment and agree that the consent of either of them shall not be required for such sale). (ii) The sale or other transfer of Participation Interests (defined below) in the Tranche B Loans to any person or entity: (iii) Following the occurrence and during the continuance of an Event of Default, the assignment or other sale of a Participating Interest or other interest of all or any portion of the Tranche B Loans. The term "Participation Interest" shall mean an undivided percentage interest in the Tranche B Loans in respect to which the holder of the Tranche B Loans may take any action with respect to the Tranche B Loans without obtaining such participant's consent except for the following: (i) Any change in such participant's percentage interest in the Tranche B Loans; (ii) Any reduction in principal amount of the Tranche B Loans (other than by virtue of payments received from or for the account of, the Company). (iii) Any postponement of the scheduled date for payment of any principal, interest of fees on account of the Tranche B Loans (including, without limitation, the Maturity Date). (iv) Any reduction of the interest rate or fees payable in respect to the Tranche B Loans; or (v) Release of any Collateral. In the event that the Tranche B Lender assigns its right under this Agreement or in respect to the Tranche B Loans, the assignee shall thereupon succeed to all of the rights, powers, privileges and duties of the Tranche B Lender hereunder to the extent of the interest so assigned to it. In the event that the Tranche B Lender, sells one or more participation interests in the Tranche B Loans, such Participant shall not be deemed to constitute a Lender hereunder. The Company, Agent and each Tranche A Lender hereby authorizes each Tranche B Lender to disclose to any potential Participant or assignee, any and all financial or other information such Tranche B Lenders may possess, concerning the Company and its affiliates whether obtained prior to or subsequent to the date of entry into this Financing Agreement, provided that such potential Participant or assignee agrees to maintain the confidentiality of such information, and to not engage in any transaction involving the Company's securities while in possession of, any material nonpublic information relating to the Company. 26 (f) The following Section 13.11 is hereby added to the Financing Agreement: So long as the Agency Agreement is in effect any assignment of the Tranche A Loans or Tranche B Loans shall only be effective if the assignee has agreed in writing to be bound to the Agency Agreement and that its interest in the loans is subject to the provisions of the Agency Agreement. 11. Amendments to Section 14. (a) Section 14 of the Financing Agreement is hereby deemed deleted in its entirety in light of the entry of the Agent and Lenders into the Agency Agreement on the date hereof provided, however, that the provisions of Section 14 shall be deemed to have been reinstated if the Agency Agreement shall cease to be in effect. 12. General Provisions 12.1 Integration; Amendment; Waivers. This Sixth Amendment and the Loan Documents set forth in full all of the terms of the agreement between the parties and are intended as the full, complete and exclusive contract governing the relationship between the parties, superseding all other discussions, promises, representations, warranties, agreements and the understandings between the parties with respect thereto. No term of this Agreement or the Loan Documents may be modified or amended, nor may any rights thereunder be waived, except in a writing signed by the party against whom enforcement of the modification, amendment or waiver is sought. Any waiver of any condition in, or breach of, any of the foregoing in a particular instance shall not operate as a waiver of other or subsequent conditions or breaches of the same or a different kind. Any Agent's or Lender's exercise or failure to exercise any rights under any of the foregoing in a particular instance shall not operate as a waiver of its right to exercise the same or different rights in subsequent instances. Except as expressly provided to the contrary in this Sixth Amendment, or in another written agreement, all the terms, conditions, and provisions of the Loan Documents shall continue in full force and effect. 12.2 Payment of Expenses. Without limiting the terms of the Loan Documents, the Company shall pay all reasonable costs and expenses incurred by or on behalf of Agent and each Lender (including reasonable attorneys' fees and expenses) arising under or in connection with this Sixth Amendment or the other Loan Documents, including without limitation, in connection with (i) the negotiation, preparation, execution and delivery of this Sixth Amendment and the Loan Documents, and any and all consents, waivers or other documents or instruments relating thereto, (ii) the filing and recording of any Sixth Amendment or any Loan Document and any other documents or instruments or further assurances filed or recorded in connection with any Loan Document, (iii) any other action required in the course of administration hereof, including, but not limited to, all reasonable fees and expenses arising out of any audits, appraisals, and inspections, and (iv) the defense or enforcement of the Loan Documents, whether or not there is any litigation between the parties. All reasonable costs and expenses shall be added to the Obligations, as Agent shall determine, and shall earn interest at the highest rate provided for under the Loan Documents. 12.3 No Third Party Beneficiaries. This Sixth Amendment does not create, and shall not be construed as creating, any rights enforceable by any Person not a party to this Sixth Amendment. 12.4 Separability. If any provision of this Sixth Amendment is held by a court of competent jurisdiction to be invalid, illegal or unenforceable, the remaining provisions of this Agreement shall nevertheless remain in full force and effect. 12.5 Counterparts. This Sixth Amendment may be executed in any number of counterparts, which together shall constitute one and the same agreement. 12.6 Time of Essence. Time is of the essence with respect to each of the Obligations of the Company with respect to all conditions to be satisfied by the Company. 27 12.7 Statute of Limitations. The Company waives the benefit of all statute(s) of limitations in any action or proceeding based upon or arising out of the Financing Agreement or the other Loan Documents. 12.8 Construction; Voluntary Agreement; Representation by Counsel. This Sixth Amendment has been prepared through the joint efforts of all the parties. Neither its provisions nor any alleged ambiguity shall be interpreted or resolved against any party on the ground that such party's counsel was the draftsman of this Sixth Amendment. Each of the parties declares that such party has carefully read this Agreement and the agreements, documents and instruments being entered into in connection herewith and that such party knows the contents thereof and signs the same freely and voluntarily. The parties hereto acknowledge that they have been represented in negotiations for and preparation of this Sixth Amendment and the agreements, documents and instrument being entered into in connection herewith by legal counsel of their own choosing, and that each of them has read the same and had their contents fully explained by such counsel and is fully aware of their contents and legal effect. This Sixth Amendment shall not be construed against any Agent or any Lender as a result of such Agent's or such Lender's involvement with its preparation. 12.9 Further Assurances. Each party hereto agrees to take all further actions and execute all further documents as any other party hereto may from time to time reasonably request to carry out the transactions contemplated by this Sixth Amendment including, without limitation, (i) the Company's filing of any UCC financing statements or taking other measures deemed reasonably necessary by the Agent to perfect its lien on the Collateral and (ii) the Agent's filing of UCC-3 termination statements as necessary to terminate all UCC Financing Statements and take all actions necessary to terminate all other security arrangements at such time as all of the Obligations have been indefeasibly satisfied in full. 28 IN WITNESS HEREOF, the parties hereto have caused this Sixth Amendment to Financing Agreement to be executed, agreed to, accepted and delivered by their proper and duly authorized officers as administered under the seal as of the dates set forth above. COMPANY: FACTORY 2-U STORES, INC., a Delaware corporation By: /s/ Douglas C. Felderman Print Name: Douglas C. Felderman Title: Executive Vice President, Chief Financial Officer AGENT: THE CIT GROUP/BUSINESS CREDIT, INC., as Agent By: /s/ Mick Richman Print Name: Mick Richman Title: Vice President TRANCHE A LENDERS: THE CIT GROUP/BUSINESS CREDIT, INC., As a Tranche A Lender By: /s/ Mike Richman Print Name: Mick Richman Title: Vice President Tranche A Dollar Commitment $50,000,000 Tranche A Percentage Commitment 100% TRANCHE B LENDER: GB RETAIL FUNDING, LLC, Tranche B Lender By: /s/ Lawrence E. Klaff Print Name: Lawrence E. Klaff Title: Managing Director 29 LIST OF EXHIBITS AND SCHEDULES Schedule 1 - Existing Liens Schedule 2 - Collateral Locations, Chief Executive Office and Trade Names, Closed Stores Schedule 3 - Litigation Schedule 4 - Taxes Schedule 5 - Depository Accounts Schedule 6 - Fiscal 2003 Borrowing Base Certificate Delivery Dates Schedule 7 - Reports 30 EX-10 5 exhempagtmr.txt EMPLOYMENT AGREEMENT MR Exhibit 10.14 EMPLOYMENT AGREEMENT THIS EMPLOYMENT AGREEMENT, dated as of January 6, 2003, by and between Factory 2-U Stores, Inc. (the "Company"), a Delaware corporation, and Melvin Redman, who currently resides in Phoenix, Arizona ("Executive"). W I T N E S S E T H WHEREAS, the Company desires to employ Executive, and Executive desires to accept such employment on the terms and conditions set forth in this Agreement. NOW, THEREFORE, in consideration of the promises and mutual covenants contained herein and for other good and valuable consideration, the Company and Executive agree as follows: 1. Term of Employment. Except upon earlier termination as provided in Section 9 hereof, Executive's employment under this Agreement shall be for a one-year term commencing on the date of this Agreement (the "Effective Date") and terminating on January 6, 2004; provided, however, that at the scheduled end of the employment term, and on each anniversary of such date, the employment term shall automatically be extended for a one-year period unless the Company or the Executive gives notice to the other at least 90 days before an extension is to take effect that they do not desire the employment term to be extended. The term of employment, as so extended from time to time, is referred to in this Agreement as the "Employment Term." 2. Positions. (a) Executive shall serve as Executive Vice President-Store Operations and Distribution of the Company. Executive shall report to the Chief Executive Officer of the Company ("CEO") and shall have such duties and authority, consistent with his position as Executive Vice President-Store Operations and Distribution of the Company, as shall be assigned to him from time to time by the CEO. (b) During the -Employment Term, Executive shall, without additional compensation, perform such executive and consulting services for, or on behalf of, such subsidiaries or affiliates of the Company as the CEO may, from time to time, request. The Company and such subsidiaries and affiliates are hereinafter referred to, collectively, as the "Company" and, individually, as a "Constituent Corporation." For purposes of this Agreement, the term "Affiliate" shall have the meaning given in the Securities Exchange Act of 1934, as amended (the "Act"). (c) During the Employment Term, Executive shall devote substantially all of his business time and efforts to the performance of his duties hereunder; provided, however, that Executive shall be permitted, to the extent that such activities do not materially interfere with the performance of his duties and responsibilities hereunder, to manage his personal financial and legal affairs and to serve on not more than three corporate, civic or charitable boards or committees. Notwithstanding the foregoing, the Executive shall not serve on any corporate board of directors or similar body if such service would be inconsistent with his fiduciary responsibilities to any Constituent Corporation and in no event shall Executive serve on any such board or other body unless approved by the CEO, which approval shall not be unreasonably withheld. Executive's current service on the board of directors of Win-Holt Manufacturing Co., Inc. is hereby approved. Executive shall, within three months after the Effective Date, relocate his principal residence to a location not more than fifty (50) miles from the Company's executive offices in San Diego, California. 3. Base Salary. During the Employment Term, the Company shall pay to the Executive a base salary at the annual rate of not less than Five Hundred Thousand Dollars ($500,000). Base salary shall be payable in accordance with the usual payroll practices of the Company. Executive's base salary shall be subject to annual review by the CEO and may be increased, but not decreased, from time to time at the discretion of the CEO. The base salary, as determined as aforesaid from time to time, shall constitute "Base Salary" for purposes of this Agreement. 4. Bonuses. (a) Not later than 30 days after Executive's entering into this Agreement, the Company shall pay to the Executive a signing bonus in the amount of $100,000. (b) Not later than 30 days after the Effective Date, Executive shall prepare and present to the CEO written financial, operational and other objectives (the "Performance Objectives") for the Company's fiscal year ending February 3, 2004. If such Performance Objectives are approved and accepted by the CEO, Executive's target bonus for such fiscal year shall be equal to 50% of Executive's annual Base Salary for such year. For each fiscal year during the Employment Term thereafter, Executive shall prepare and submit Performance Objectives to the CEO during the normal course of the Company's planning cycle and before the commencement of the new fiscal year. If such subsequent Performance Objectives are accepted and approved by the CEO, Executive's target bonus for such fiscal years shall be based on 50% of Executive's Base Salary in effect as of the start of such fiscal year. In the event of any disagreement between the CEO and Executive concerning the acceptance and approval of Performance Objectives, the CEO and Executive shall negotiate in good faith to attempt to resolve such differences. Annual bonuses shall be reduced pro rata for any fiscal year that is not a full year (based on the actual number of days of such year included in the Employment Term). Each annual bonus shall be paid no later than 30 days after the Company's audited financial statements with respect to the year for which the annual bonus is awarded are available. If the Performance Objectives accepted by the CEO are exceeded in any year, the annual bonus shall be increased by 1% of Base Salary for each 1% of excess, up to a maximum bonus of 100% of Base Salary for the achievement of 150% of the Performance Objectives. If the Performance Objectives accepted by the CEO are not met, the Executive shall not be entitled to any bonus. (c) To the extent that the Executive's bonus and base salary in any fiscal year is in excess of $1 million, payment of an amount equal to such excess shall be automatically deferred. Amounts deferred under this Paragraph 4(c) shall be credited annually with interest at the Company's borrowing rate and shall be paid to Executive (or to his estate, in the case of death) in a single lump sum three months following his termination of employment. Amounts deferred under this Paragraph 4(c) shall represent an unfunded, unsecured obligation of the Company. The Company will establish a "rabbi trust" reasonably acceptable to Executive and will fund its deferred compensation obligation to Executive by transferring to such rabbi trust, cash or other assets sufficient to satisfy such obligation. 5. Equity Compensation. (a) Non-Qualified Stock Options. The Company will grant to Executive, pursuant to the Company's Second Amended and Restated 1997 Stock Option Plan (the "Plan"), if approved by the stockholders at the Company's next annual meeting of stockholders or, if such approval is not obtained, by contract not subject to the Plan, nonqualified options entitling Executive to acquire a total of 125,000 shares of the Company's common stock at the closing market price of such common stock on the commencement date of the Employment Term. Subject to Executive's continued employment under this Agreement, such nonqualified stock options will vest in increments of 7,812.5 shares (each, a "Tranche") on each December, March, June and September 30 during the first four years of the Employment Term. The non-qualified options in each such Tranche shall be exercisable for a period of five years after the vesting of such Tranche. During any period of time after one year from the date of this Agreement that shares acquired upon exercise of such non-qualified options would not be saleable by Executive pursuant to Rule 144 under the Act or pursuant to an effective registration statement under the Act, the Company shall file with the Securities and Exchange Commission and maintain the effectiveness of a registration statement on Form S-8 (or such successor or replacement form as may be applicable) to permit Executive to resell shares of common stock acquired upon exercise of such non-qualified stock options. The terms of such nonqualified stock options will be more specifically set forth in a Stock Option Agreement substantially in the form attached as Exhibit A. (b) Restricted Stock. The Company will grant to Executive pursuant to the Plan, if approved by the stockholders at the Company's next annual meeting of stockholders or, if such approval is not obtained, by contract not subject to the Plan, one hundred twenty-five thousand (125,000) restricted shares of the Company's common stock (the "Restricted Stock") at a cost to Executive of One Thousand Two Hundred Fifty Dollars ($1,250). 2 (c) Vesting. The Restricted Stock shall vest in installments as follows: 41,666.7 shares of Restricted Stock shall vest at such time as the closing market price of the Company's common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period; an additional 41,666.7 shares of restricted common stock shall vest at such time as the closing market price of the Company's common stock equals or exceeds twenty dollars ($20) per share for 20 consecutive trading days in any three-month period; and the final 41,666.7 shares of the Company's common stock shall vest at such time as the closing market price of the Company's common stock equals or exceeds thirty dollars ($30) per share for 20 consecutive trading days in any three-month period. Executive's right to receive any shares of Restricted Stock that have not so vested prior to January 6, 2008 shall terminate and any such Restricted Stock shall be retained by the Company. Notwithstanding the foregoing, Executive shall not be entitled to sell any such vested shares of Restricted Stock until the expiration of two years from the Effective Date (the "Holding Period"). The terms of such Restricted Stock will be more specifically set forth in a Restricted Stock Agreement substantially in the form attached as Exhibit B. (d) Restrictions on Restricted Stock. Until Restricted Stock has vested and the Holding Period has expired, it may not be sold, transferred, assigned or pledged. Shares of Restricted Stock shall be evidenced by stock certificates bearing appropriate legends referring to the applicable terms, conditions and restrictions. Stock certificates representing the Restricted Stock will be registered in the name of Executive as of the date of this Agreement, but such certificates will be held by the Company until the shares vest and the Holding Period has expired, and Executive shall deliver to the Company a stock power, endorsed in blank, relating to the shares of Restricted Stock. At such time as Restricted Stock vests, and the expiration of the Holding Period with regard to such vested shares of Restricted Stock, a certificate representing such shares (less any shares retained by the Company to satisfy Executive's tax withholding obligations) will be delivered to Executive as soon as practicable. (e) Dividends and Voting. From and after the date of issuance of the Restricted Stock, Executive will have, with respect to the Restricted Stock, all the rights of a holder of common stock, including the right to receive any dividends or distributions paid on the common stock and the right to vote the shares of Restricted Stock. (f) Income Tax. Executive shall be required to make arrangements satisfactory to the Company to satisfy any applicable federal, state or local tax liability arising with respect to the Restricted Stock. Such arrangements may be satisfied by either making a cash payment to the Company of the required amount or by having the Company retain Restricted Stock having a value equal to the amount of Executive's federal, state and local tax obligation from the shares of Restricted Stock otherwise deliverable to Executive upon the vesting of such Restricted Stock and expiration of the Holding Period. If Executive fails to satisfy the obligations in a time and manner satisfactory to the Company, the Company may withhold all required amounts from Executive's compensation or other amounts payable under this Agreement to satisfy such federal, state and local tax obligations. Executive shall be solely responsible for determining whether to make, and for making, any election under Section 83(b) of the Internal Revenue Code of 1986 (as amended) with respect to the Restricted Stock. (g) Effect and Other Benefits. Income recognized by Executive as the result of the grant or vesting of Restricted Stock, the expiration of the Holding Period or the receipt of dividends, unrestricted stock will not be included in any formula for calculating benefits under this Agreement or any benefit plan of the Company. 6. Employment Benefits and Vacation. (a) During the Employment Term, Executive shall also be entitled to participate in all pension, retirement, savings, welfare and other pension and welfare employee benefit plans and arrangements and fringe benefits and perquisites generally maintained by the Company from time to time for the benefit of senior executives of the Company, in accordance with their respective terms as in effect from time to time (other than any special arrangement entered into by contract with an executive). (b) During the Employment Term, Executive shall be entitled to vacation each year in accordance with the Company's policies in effect from time to time, but in no event less than four (4) weeks paid vacation per calendar year. Executive shall also be entitled to such sick leave as is customarily provided by the Company for its senior executive employees. 3 7. Moving Expenses. The Company will reimburse Executive on an after-tax basis for all reasonable expenses incurred by the Executive (i) for the relocation of his family to San Diego for the purpose of commencing Executive's employment pursuant to this Agreement, including one customary real estate commission, (ii) for interim living expenses in the San Diego area reasonably incurred to maintain Executive's normal standard of living for up to two years and (iii) for up to two trips to the San Diego area for Executive and Executive's spouse for the purpose of locating a residence. In the event that Executive's employment is terminated by the Company without Cause or Executive terminates his employment with the Company for Good Reason, in each case within one year after the Effective Date, the Company will reimburse Executive for all reasonable expenses incurred by Executive in the relocation of his family to Phoenix, Arizona. 8. Business Expenses; Vehicle Allowance. (a) Executive shall be reimbursed for the travel, entertainment and other business expenses incurred in the performance of his duties hereunder, in accordance with policies generally applicable to senior executives of the Company as in effect from time to time. (b) During the Employment Term, the Company shall provide a vehicle allowance to Executive in the amount of $750 per month. 9. Termination. (a) The employment of Executive under this Agreement shall terminate on the expiration of the Employment Term and earlier upon the occurrence of any of the following events: (i) the death of Executive; (ii) the termination by the Company of Executive's employment due to Executive's Disability pursuant to Section 9(b) hereof; (iii) the termination by Executive of Executive's employment for Good Reason pursuant to Section 9(c) hereof; (iv) the termination by the Company of Executive's employment without Cause; (v) the termination by Executive of Executive's employment without Good Reason upon sixty (60) days prior written notice; or (vi) the termination by the Company of Executive's employment for Cause pursuant to Section 9(e) hereof. (b) Disability. If, by reason of the same or related physical or mental reasons, Executive is unable to carry out his material duties pursuant to this Agreement for more than three (3) months in any twelve (12) consecutive month period, the Company may terminate Executive's employment for Disability upon thirty (30) days prior written notice. (c) Termination for Good Reason. A Termination for Good Reason means a termination by Executive by written notice given within ninety (90) days after the occurrence of the Good Reason event. For purposes of this Agreement, "Good Reason" shall mean the occurrence or failure to cause the occurrence, as the case may be, without Executive's express written consent, of any of the following circumstances, unless such circumstances are corrected prior to the date of termination specified in the Notice of Termination for Good Reason (as defined in Section 9(d) hereof): (i) the material breach by the Company of any of its obligations to Executive under this Agreement; (ii) any material diminution of Executive's positions, duties or responsibilities hereunder, as of the Effective Date (except in each case in connection with the termination of Executive's employment for Cause or Disability or as a result of Executive's death, or temporarily as a result of Executive's illness or other absence and provided that a reduction in the size or number of the units reporting to Executive as a result of dispositions, shall not be a material diminution), or the assignment to Executive of duties or responsibilities that are inconsistent with Executive's position as the Executive Vice President-Store Operations and Distribution of the Company; (iii) removal of, or the nonreelection of, the Executive from his position as the Executive Vice President-Store Operations and Distribution of the Company; (iv) a relocation of the principal executive offices of the Company to a location more than seventy-five (75) miles from its current location in San Diego, California, or a relocation of Executive away from such principal executive office; (v) failure by the CEO and Executive to agree on Performance Objectives, after good faith negotiations, within 60 days after submission to the CEO by Executive; or (vi) any change in the Company's Certificate of Incorporation or Bylaws not approved by Executive that materially and adversely diminish Executive's rights to indemnification in his capacity as an officer or director of the Company. 4 (d) Notice of Termination of Good Reason. A Notice of Termination for Good Reason shall mean a notice that shall indicate the specific termination provision in Section 9(c) relied upon and shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for Termination for Good Reason. The Notice of Termination for Good Reason shall provide for a date of termination not less than ten (10) nor more than sixty (60) days after the date such Notice of Termination for Good Reason is given. (e) Cause. Subject to the notification provisions of Section 9(f) below, Executive's employment hereunder may be terminated by the Company for Cause. For purposes of this Agreement, the term "Cause" shall be limited to (i) willful misconduct by Executive with regard to the Company; (ii) the refusal of Executive to follow the proper written direction of the Board; provided, however, that the foregoing refusal shall not be "Cause" if Executive in good faith believes that such direction is illegal, unethical or immoral and promptly so notifies in writing the entity or person giving the direction; (iii) Executive being convicted of a felony; (iv) the willful breach by Executive of any fiduciary duty owed by Executive to any Constituent Corporation which has a material adverse effect on the Company; or (v) Executive's material fraud with regard to any Constituent Corporation. (f) Notice of Termination for Cause. A Notice of Termination for Cause shall mean a notice that shall indicate the specific termination provision in Section 9(e) relied upon and shall set forth in reasonable detail the facts and circumstances which provide a basis for Termination for Cause. The date of termination for a Termination for Cause shall be the date indicated in the Notice of Termination. Any purported Termination for Cause which is held by a court not to have been based on the grounds set forth in this Agreement shall be deemed a Termination without Cause. 10. Consequences of Termination of Employment. (a) Death. If Executive's employment is terminated during the Employment Term by reason of Executive's death, the employment period under this Agreement shall terminate without further obligations to the Executive's legal representatives under this Agreement except for (i) any compensation earned but not yet paid, including and without limitation, any declared but unpaid bonus, any amount of Base Salary or deferred compensation accrued or earned but unpaid, any accrued vacation pay payable pursuant to the Company's policies and any unreimbursed business expenses payable pursuant to Section 8, which amounts shall be promptly paid in a lump sum to Executive's estate; (ii) the product of (x) the target annual bonus for the fiscal year of Executive's death, multiplied by (y) a fraction, the numerator of which is the number of days of the current fiscal year during which Executive was employed by the Company, and the denominator of which is 365, which bonus shall be paid if and when bonuses for such period are paid to the other executive officers of the Company; (iii) subject to Section 11 hereof, any other amounts or benefits owing to Executive under the then applicable employee benefit plans or policies of the Company, which shall be paid in accordance with such plans or policies; and (iv) payment of the spouse's and dependent's COBRA coverage premiums to the extent, and as long as, they remain eligible for COBRA coverage, but in no event more than three (3) years. (b) Disability. If Executive's employment is terminated by reason of Executive's Disability, Executive shall be entitled to receive the payments and benefits to which his representatives would be entitled in the event of a termination of employment by reason of his death; provided that the payment of Base Salary shall be reduced by the projected amount he would receive under any long-term disability policy maintained by the Company or program maintained by the Company during the twelve (12) month period during which Base Salary is being paid. (c) Termination by Executive for Good Reason or for Change in Control. If (i) Executive terminates his employment hereunder for Good Reason during the Employment Term; or (ii) a Change in Control occurs and within 180 days thereafter Executive terminates his employment for any reason, Executive shall be entitled to receive the payments and benefits to which his representatives would be entitled in the event of a termination of employment by reason of his death plus payment on a monthly basis of twelve (12) months of Base Salary in effect as of the start of the fiscal year in which such termination occurs, in accordance with usual Company payroll practices. In addition, in the event Executive terminates his employment as a result of a Change of Control, Executive's non-qualified stock options shall immediately vest and become exercisable and Executive's Restricted Stock shall immediately vest. 5 (d) Termination With Cause or Voluntary Resignation Without Good Reason. If Executive's employment hereunder is terminated (i) by the Company for Cause; or (ii) by Executive without Good Reason except within 180 days following a Change in Control, the Executive shall be entitled to receive only his Base Salary through the date of termination, any earned but unpaid bonus for such year, any unreimbursed business expenses payable pursuant to Section 8 and any other benefits subject to Section 10(a)(iii) hereof to which he is entitled by law. All other benefits (including, without limitation, rights to retain Restricted Stock and rights to exercise options) due Executive shall terminate upon such termination of employment. (e) Non Renewal by the Company or Termination by the Company Without Cause. If this Agreement is not renewed by the Company at the end of the Employment Term or Executive's employment is terminated by the Company without cause, Executive shall be entitled to receive the payment and benefits to which his representatives would be entitled in the event of a termination of employment by reason of his death plus payment on a monthly basis of twelve (12) months of Base Salary in effect as of the start of such fiscal year, in equal shares all in accordance with usual Company payroll practices, subject to the execution, delivery and non-revocation by the Executive of a general release of claims in favor of the Company and its officers, directors, shareholders and affiliates in a form reasonably acceptable to the Company and the Executive. (f) Parachute Payments. Notwithstanding the foregoing, the benefits provided to the Executive under Section 10(c) on account of a Change in Control shall be reduced if and to the extent that a nationally recognized firm of compensation consultants or auditors designated by the Company determines that such reduction will result in a greater net after-tax benefit to the Executive than the Executive would obtain in the absence of such reduction, taking into account any excise tax payable by the Executive under Internal Revenue Code Section 4999. The allocation of the reduction required hereby among the benefits shall be determined by the Executive. 11. No Mitigation: No Set-Off. In the event of any termination of employment under Section 9, Executive shall be under no obligation to seek other employment and there shall be no offset against any amounts due Executive under this Agreement on account of any remuneration attributable to any subsequent employment that Executive may obtain. Any amounts due under Section 10 are in the nature of severance payments, or liquidated damages, or both, and are not in the nature of a penalty. Such amounts are inclusive and in lieu of any amounts payable under any other salary continuation or cash severance arrangement of the Company or any affiliate thereof and to the extent paid or provided under any other such arrangement shall be offset from the amount due hereunder. 12. Change in Control. Subject to the provisions of Section 12(b) hereof, for purposes of this Agreement, the term "Change in Control" shall mean (a) any "person" (as defined in the Act) not an affiliate of the Company on the Effective Date becomes the "beneficial owner" (as defined in Rule 13d-3 under the Act), directly or indirectly, of securities of the Company representing fifty percent (50%) or more of the combined voting power of the Company's then outstanding securities; (b) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board, and any new director (other than a director designated by a person who has entered into an agreement with the Company to effect a transaction described in this paragraph) whose election by the Board of the Company or nomination for election by the Company's stockholders was approved by a vote of at least two-thirds of the directors then still in office who either were directors at the beginning of the two-year period or whose election or nomination for election was previously so approved, cease for any reason to constitute at least a majority of the Board; (c) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) more than fifty percent (50%) of the combined voting power of the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation; or (d) the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of all or substantially all of the Company's assets other than the sale of all or substantially all of the assets of the Company to a person or persons who beneficially own, directly or indirectly, at least fifty percent (50%) or more of the combined voting power of the outstanding voting securities of the Company at the time of the sale. 6 13. Confidential Information, Non-Competition and Non-Solicitation of the Company. (a) (i) Executive acknowledges that, as a result of his employment hereunder, Executive will obtain secret and confidential information of the Company and the Company will suffer substantial damage, which would be difficult to ascertain and in an amount which would be difficult to compute, if Executive should use any of such confidential information and that because of the nature of the information that will be known to Executive, it is necessary for the Company to be protected by the prohibition against Competition as set forth herein, as well as the Confidentiality restrictions set forth herein. (ii) Executive acknowledges that the retention of non-clerical employees of the Company, in which the Company has invested training and on which the Company depends for the operation of its business, is important to the businesses of the Company; Executive will obtain unique information as to such employees as an executive of the Company and will develop a unique relationship with such persons as a result of being an executive of the Company; and, therefore, it is necessary for the Company to be protected from Executive's Solicitation of such employees as set forth below. (iii) Executive acknowledges that the provisions of this Agreement are reasonable and necessary for the protection of the business of the Company and that part of the compensation paid under this Agreement and the agreement to pay severance in certain instances is in consideration for the agreements in this Section 13. (b) As used herein, "Competition" shall mean: participating, directly or indirectly, as an individual proprietor, partner, stockholder, officer, employee, director, joint venturer, investor, lender, consultant or in any capacity whatsoever (within the United States of America, or in any other country where any Constituent Corporation does business) in a business that owns or operates off price apparel and housewares stores (or any other business in which any Constituent Corporation is then engaged); provided, however, that such participation shall not include (i) the ownership of not more than one percent (1%) of the total outstanding stock of a publicly-held company; or (ii) any activity engaged in with the prior written approval of the Board. (c) As used herein, "Solicitation" shall mean recruiting, soliciting or inducing any non-clerical employee of any Constituent Corporation to terminate his or her employment with, or otherwise cease his or her relationship with, such Constituent Corporation or hiring, or assisting another person or entity to hire, any non-clerical employee of any Constituent Corporation or any person who, within six (6) months before, had been a non-clerical employee of any Constituent Corporation, unless the employment of such person by a Constituent Corporation was terminated involuntarily and without cause. (d) If any restriction set forth with regard to Competition or Solicitation is found by any court of competent jurisdiction, or an arbitrator, to be unenforceable because it extends for too long a period of time or over too great a range of activities or in too broad a geographical area, it shall be interpreted to extend over the maximum period of time, range of activities or geographic area as to which it may be enforceable. If any provision of this Section 13 shall be declared to be invalid or enforceable, in whole or in part, as a result of the foregoing, as a result of public policy or for any other reason, such invalidity shall not affect the remaining provisions of this Section, which shall remain in full force and effect. (e) During and after the Employment Term, Executive shall hold in a fiduciary capacity for the benefit of the Company all secret or confidential information, knowledge or data relating to the Company and its business, including any confidential information as to suppliers (i) obtained by Executive during his employment by the Company and (ii) not otherwise in the public domain. Executive shall not, without prior written consent of the Company, unless compelled pursuant to the order of a court or other government or legal body having jurisdiction over such matter, communicate or divulge any such information, knowledge or data to anyone other than the Company, and those designated by it. In the event Executive is compelled by order of a court or other governmental or legal body to communicate or divulge any such information, knowledge or data to anyone other than the foregoing, he shall promptly notify the Company of any such order and he shall cooperate fully with the Company in protecting such information to the full extent, possible under applicable law. 7 (f) Upon termination of his employment with the Company, or at any time the Company may request, Executive will promptly deliver to the Company, as requested, all documents (whether prepared by the Company, Executive or a third party) relating to the Company or any of its business or property which he may possess or have under his direction or control, other than his personal employment and personnel records. (g) During the Employment Term and for one (1) year thereafter, Executive will not enter into Competition with the Company; provided, however, that Executive's obligation under this sentence shall be suspended during any time when the Company is in breach of any payment obligation under Section 10(c) or 10(e) of this Agreement. Furthermore, in the event of any termination of Executive's employment for any reason whatsoever, whether by the Company or by the Executive and whether or not for Cause, Good Reason or expiration of the Employment Tem, the Executive will not engage in Solicitation for one (1) year thereafter. (h) Executive acknowledges that in the event of a breach of this Section 13, the Company will be caused irreparable injury and money damages may not be an adequate remedy. Consequently, Executive agrees that the Company shall be entitled to seek injunctive relief (in addition to its other remedies at law) to have the provisions of this Section 13 enforced. 14. Indemnification. (a) The Company agrees that if Executive is made a party to or threatened to be made a party to any action, suit or proceeding, whether civil, criminal, administrative or investigative (a "Proceeding"), by reason of the fact that he is or was a director or officer of any Constituent Corporation or is or was serving at the request of any Constituent Corporation as a director, officer, member, employee, fiduciary or agent of another corporation or of a partnership, joint venture, trust or other enterprise, including, without limitation, service with respect to employee benefit plans, whether or not the basis of such Proceeding is alleged action in an official capacity as a director, officer, member, employee, fiduciary or agent while serving as a director, officer, member, employee, fiduciary or agent, he shall be indemnified and held harmless by the applicable company to the fullest extent authorized by applicable law against all Expenses incurred or suffered by Executive in connection therewith, and such indemnification shall continue as to Executive even if Executive has ceased to be an officer, director, member, fiduciary or agent, or is no longer employed by such company, and shall inure to the benefit of his heirs, executors and administrators. (b) As used in this Agreement, the term "Expenses" shall include, without limitation, damages, losses, judgments, liabilities, fines, penalties, excise taxes, settlements and costs, attorneys' fees, accountants' fees and disbursements and costs of attachment or similar bonds, investigations and any expenses of establishing a right to indemnification under this Agreement. (c) To the extent permitted by applicable law, Expenses incurred by Executive in connection with any Proceeding shall be paid in advance upon request of Executive and the giving by the Executive of any undertakings required by applicable law. (d) Executive shall give the Company notice of any claim made against him for which indemnity will or could be sought under this Agreement. In addition, Executive shall give the Company such information and cooperation as it may reasonably require and as shall be within Executive's power and at such times and places as are reasonably convenient for Executive. (e) With respect to any Proceeding involving Executive: (i) The Company will be entitled to participate therein at its own expense; and (ii) Except as otherwise provided below, to the extent that it may wish, the Company will be entitled to assume the defense thereof, with counsel reasonably satisfactory to Executive, in which case Executive also shall have the right to participate and employ his own counsel in such action, suit or proceeding, but only at his own cost and expense, provided that the Company shall only be permitted to assume defense of a Proceeding if (l) the Proceeding could not result in imposition of criminal penalties against Executive and (2) the Company acknowledges that it is liable to indemnify Executive with respect to all Expenses with respect to such Proceedings, except as provided earlier in this sentence with regard to Executive's own counsel. (f) The Company shall not be liable to indemnify Executive under this Agreement for any amounts paid in settlement of any action or claim effected without its written consent. The Company shall not settle any action or claim in any manner which would impose any penalty on Executive (except a penalty in respect of which Executive is fully indemnified hereunder) without Executive's written consent. Neither the Company nor Executive will unreasonably withhold or delay consent to any proposed settlement. 8 (g) The right to indemnification and the payment of expenses incurred in defending a Proceeding in advance of its final disposition conferred in this Section 14 shall not be exclusive of any other right which Executive may have or hereafter may acquire under any statute, provision of the certificate of incorporation or by-laws of the Company, agreements, vote of stockholders or disinterested directors or otherwise. (h) The Company shall obtain officer and director liability insurance policies covering Executive in the same aggregate amount and under the same terms as are currently maintained by the Company for senior officers and directors and use commercially reasonable efforts to maintain such policies or replacement policies with substantially the same limits in effect during the term of Executive's employment by the Company. 15. Miscellaneous. (a) Entire Arrangement/Amendments. This Agreement and the instruments contemplated herein, contain the entire understanding of the parties with respect to the employment of Executive by the Company. There are no restrictions, agreements, promises, warranties, covenants or undertakings between the parties with respect to the subject matter hereof other than those expressly set forth herein and therein. This Agreement may not be altered, modified or amended except by written instrument signed by the parties hereto. (b) No Waiver. The failure of a party to insist upon strict adherence to any term of this Agreement on any occasion shall not be considered a waiver of such party's rights or deprive such party of the right thereafter to insist upon strict adherence to that term or any other term of this Agreement. Any such waiver must be in writing and signed by Executive or an authorized officer of the Company, as the case may be. (c) Assignment. This Agreement shall not be assignable by Executive. This Agreement shall be assignable by the Company, but only to another Constituent Corporation and only if such Constituent Corporation promptly assumes all of the obligations hereunder of the Company in a writing delivered to the Executive and otherwise complies with the provisions hereof with regard to such assumption. Upon such assignment and assumption, all obligations of the Company herein shall be the obligations of the assignee entity or acquiror, as the case may be, but the Company shall remain secondarily liable for the obligations hereunder. (d) Successors; Binding Agreement. This Agreement shall inure to the benefit of and be binding upon the personal or legal representatives, executors, administrators, successor, heirs, distributees, devisees legatees and permitted assignees of the parties hereto. (e) Communications. For the purpose of this Agreement, notices and all other communications provided for in this Agreement shall be in writing and shall be deemed to have been duly given (i) when faxed or delivered in person; or (ii) two business days after mailed by United States registered or certified mail, return receipt requested, postage prepaid, addressed to the respective addresses set forth on the signature page of this Agreement, provided that all notices to the Company shall be directed to the CEO of the Company or to such other address as any party may have furnished to the other in writing in accordance herewith. Notice of change of address shall be effective only upon receipt. 9 (f) Withholding Taxes. The Company may withhold from any and all amounts payable under this Agreement to Executive such Federal, state and local taxes as may be required to be withheld pursuant to any applicable law or regulation. (g) Survival. The respective rights and obligations of the parties hereunder shall survive any termination of Executive's employment to the extent necessary to the agreed preservation of such rights and obligations. (h) Counterparts. This Agreement may be signed in counterparts, each of which shall be an original, with the same effect as if the signatures thereto and hereto were upon the same instrument. (i) Headings. The headings of the sections contained in this Agreement are for convenience only and shall not be deemed to control or affect the meaning or construction of any provisions of this Agreement. (j) Notwithstanding anything to the contrary in this Agreement, the Company shall not be required to take any action or make any payment to the extent such action or payment would be inconsistent with or violate the provisions of the Sarbanes-Oxley Act of 2002. 10 IN WITNESS WHEREOF, the parties hereto have duly executed this Agreement as of the day and year first above written, FACTORY 2-U STORES, INC. By: /s/ William R. Fields William R. Fields, Chief Executive Officer Address: 4000 Ruffin Road San Diego, California 92123-1866 Telephone: (858) 627-1800 Fax: (858) 637-4199 /s/ Melvin C. Redman Melvin C. Redman Address: 6712 East Cheney Drive Paradise Valley, Arizona 85253 Home Phone: (480) 948-2475 Home Fax: (480) 443-3460 Office Phone: (480) 634-6211 Offix Fax: (480) 634-6215 11 Exhibit A FACTORY 2 -U STORES, INC. NONQUALIFIED STOCK OPTION AGREEMENT No. of Shares: 125,000 Date: January 6, 2003 This is to confirm that Factory 2-U Stores, Inc. ("Factory 2-U") has granted Melvin Redman ("you") a nonqualified stock option under Factory 2-U's Second Amended and Restated 1997 Stock Option Plan (the "Plan") to purchase up to 125,000 shares (the "Option Shares") of common stock, par value $0.01 per share, of Factory 2-U, on the following principal terms: 1. When Option can be Exercised. Subject to your continued employment under that certain Employment Agreement (the "Employment Agreement") between Factory 2-U and you of even date herewith, the Option will vest in increments with respect to 7,812.50 shares (each, a "Tranche") on each December, March, June and September 30 during the first four years of the Employment Term (as defined in the Employment Agreement). The Option with respect to each such Tranche shall be exercisable for a period of five years after the vesting of such Tranche. The Option may also terminate as described in Paragraph 4 or as described in the Plan. Under some circumstances described below or described in the Plan, the Option will become exercisable in full, even before the date stated in the first sentence to be the earliest date on which the Option may be exercised. 2. Exercise Price. The price which must be paid for Option Shares if the Option is exercised will be $3.13 per share. However, that exercise price may be adjusted as provided in the Plan to take account of certain types of corporate actions, such as stock dividends, stock splits, share combinations, recapitalizations or reorganizations. The exercise price must be paid by certified check or by tendering shares of Factory 2-U common stock with a market value on the day those shares are tendered (based on the last reported sale price of Factory 2-U common stock on that day) equal to the exercise price. 3. How to Exercise the Option. To exercise the Option, you must give a written notice of the exercise to Factory 2-U at its principal executive office, to the attention of its Secretary, accompanied by payment of the exercise price by certified check or by a tender of shares. A suggested form of notice of exercise is attached to this Agreement. The Option will be deemed exercised when Factory 2-U receives the notice of exercise accompanied by payment of the exercise price in cash or by tender of shares. A certificate for the number of shares as to which the Option is exercised will be sent to you as soon as practicable after the day on which the Option is exercised. That certificate may bear a legend stating that the shares represented by it have not been registered under the Securities Act of 1933, as amended, and may be sold or transferred only in a transaction which is registered under that Act or is exempt from the registration requirements of that Act. 4. Termination under Some Circumstances. If you cease to be employed by Factory 2-U or a subsidiary: (a) if the reason your employment terminates is your death or total disability, the Option will expire at the end of the 12 month period following the day on which your employment terminates; (b) if the reason your employment terminates is your retirement after you reach the age of 65, your voluntary resignation with the consent of Factory 2-U (which Factory 2-U will be under no obligation to give) or the termination of your employment by Factory 2-U other than for Cause (as defined in the Employment Agreement), the Option will expire at the end of the three month period following the day on which your employment terminates; and (c) if your employment terminates other than for a reason described in subparagraph (a) or (b), the Option will expire on the day on which your employment terminates. 5. Change of Control. In the event of a Change of Control, as defined in the Employment Agreement, the Options shall immediately vest and become exercisable. 6. Prohibition against Assignments. During your lifetime, the Option may be exercised only by you, or by your guardian or legal representative, if you become unable to act. After your death, the Option may be exercised by the executor of your estate or your other personal representative, or by the persons to whom the right to exercise the Option has passed under your will or through the laws of descent and distribution. The Option may not be assigned, pledged or hypothecated in any way, may not be subject to execution by a creditor or any other person and may not be transferred other than by will or the laws of descent and distribution. Any attempted assignment, transfer, pledge, hypothecation or other disposition of the Option which is not specifically permitted by the Plan will be void. 7. Not a Stockholder. You will have no rights as a stockholder of Factory 2-U because of the Option until you exercise the Option and receive shares as a result of the exercise. 8. No Guarantee of Employment. The fact that you have been granted an Option will not give you any right to continue in the employ of Factory 2-U or a subsidiary, and will not interfere with or restrict any right Factory 2-U or a subsidiary may have to discharge you as an employee, or any right you have under an employment contract or otherwise to continue to be employed by Factory 2-U or a subsidiary. 9. Compliance with Securities Laws. Factory 2-U's obligation to issue shares to you upon exercise of the Option is subject to the condition that the issuance of the shares will be in compliance with the Securities Act of 1933, as amended, and all other applicable laws and regulations, and that the stock you will be purchasing by exercising the Option will be authorized for listing on any securities exchange on which Factory 2-U's common stock may in the future be listed. 10. Withholding of Taxes. If Factory 2-U is required to pay withholding tax because of your exercise of the Option, you may direct Factory 2-U to (i) withhold shares you purchase by exercising the Option or Restricted Shares granted pursuant to your Employment Agreement that have vested as of such time, (ii) require you to pay Factory 2-U a sum equal to the sum Factory 2-U must withhold before Factory 2-U will issue stock to you as a result of your exercising the Option or (iii) deduct the sum which must be withheld from one or more installments of your compensation. If you fail to so direct Factory 2-U, Factory 2-U may elect any such alternatives. If you make an election under Section 83(b) of the Internal Revenue Code in connection with your exercise of the Option, you must notify Factory 2-U of that fact. 11. Plan Controls. If there is any inconsistency between the terms of the Plan and the terms of this Agreement, the terms of the Plan will control. The Committee which administers the Plan will have authority to interpret the Plan and this Agreement. 12. Stockholder Approval. Notwithstanding anything to the contrary herein, in the event that an amendment to the Plan has not been approved by the Company's stockholders at or before the Company's next annual meeting of stockholders, the Option granted hereby shall for all purposes be deemed to be a contractual nonqualified stock option with the same terms and conditions except that it shall not be deemed granted under or subject to the Plan. A-2 13. Amendments. The Board of Directors of Factory 2-U may at any time modify or amend the Plan. However, no modification or amendment of the Plan will affect your rights as the holder of this Option without your consent. FACTORY 2-U STORES, INC. By: /s/ William R. Fields William R. Fields Chairman & Chief Executive Officer ACCEPTED: /s/ Melvin Redman Melvin Redman A-3 NOTICE OF EXERCISE Secretary Factory 2-U Stores, Inc. 4000 Ruffin Road San Diego, CA 92123 Dear Sir or Madam: This is to notify you that I am exercising the Option, dated January 6, 2003 granted to me under the Factory 2-U Stores, Inc. Second Amended and Restated 1997 Stock Option with regard to __________ shares of Common Stock. The exercise price specified in my Option Agreement is $3.13 per share. In order to pay the exercise price, I: enclose a certified check in the amount enclose certificates representing shares of Factory 2-U common stock with a fair market value on the date of this Notice (based upon the last reported sale price of Factory 2-U common stock on the date of this Notice) equal to the exercise price for all the shares as to which I am exercising this Option. Dated: _______________ Very truly yours, (Print Name) (Signature) (Social Security Number) A-4 Exhibit B FACTORY 2-U STORES, INC. RESTRICTED STOCK AGREEMENT January 6, 2003 Melvin Redman c/o Factory 2-U Stores, Inc. 4000 Ruffin Road San Diego, California 92123-1866 Dear Mel: This letter sets forth the terms and conditions of the shares of restricted stock granted to you by Factory 2-U Stores, Inc. (the "Company"), in accordance with the provisions of its Second Amended and Restated 1997 Stock Option Plan (the "Plan"). You have been granted 125,000 restricted shares (the "Restricted Shares") of the Company's Common Stock ("Common Stock"). Your Restricted Shares are subject to the terms and conditions set forth in the Plan, any rules and regulations adopted by the Compensation committee of the Board of Directors (the "Committee") and this letter. Any terms used in this letter and not defined have the meanings set forth in the Plan. 1. Vesting of Restricted Shares (a) Unless they vest on an earlier date as provided in paragraphs 4 and 5 below, your Restricted Shares will vest in installments as follows, provided that you are an employee of the Company or its subsidiaries on each such date: 41,666.7 Restricted Shares shall vest at such time as the closing market price of the Common Stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period; an additional 41,666.7 Restricted Shares shall vest at such time as the closing market price of the Common Stock equals or exceeds twenty dollars ($20) per share for 20 consecutive trading days in any three-month period; and the final 41,666.7 Restricted Shares shall vest at such time as the closing market price of the Common Stock equals or exceeds thirty dollars ($30) per share for 20 consecutive trading days in any three-month period. Your right to receive any Restricted Shares that have not so vested prior to January 6, 2008 shall terminate and any such Restricted Shares shall be retained by the Company. Notwithstanding the foregoing, you shall not be entitled to sell any such vested Restricted Shares until the expiration of two years from the date hereof (the "Holding Period"). (b) You must pay One Thousand Two Hundred Fifty Dollars ($1,250) to receive the Restricted Shares granted to you by this letter. 2. Restrictions on the Restricted Shares Until Restricted Shares have vested and the Holding Period has expired, they may not be sold, transferred, assigned or pledged. Restricted Shares shall be evidenced by stock certificates bearing appropriate legends referring to the applicable terms, conditions and restrictions. Stock certificates representing the Restricted Shares will be registered in your name as of the date hereof, but such certificates will be held by the Company until the Restricted Shares vest and the Holding Period has expired, and you shall deliver to the Company a stock power, endorsed in blank, relating to the Restricted Shares. At such time as Restricted Shares vest, and the expiration of the Holding Period with regard to such vested shares, a certificate representing such shares (less any shares retained by the Company to satisfy Executive's tax withholding obligations) will be delivered to Executive as soon as practicable. 3. Dividends and Voting From the date of this letter, you will receive, with respect to your Restricted Shares, payments equal to the amount of dividends paid on Common Stock. Such payments will be paid directly to you at the same time dividends are paid with respect to all other shares of Common Stock. You will have the right to vote your Restricted Shares. 4. Termination of Employment (a) General. If your employment terminates for any reason, any of your Restricted Shares which have not vested prior to your termination of employment will be forfeited. (b) Acceleration of Vesting. The Committee may, in its discretion, declare all or any portion of your Restricted Shares immediately vested or otherwise accelerate the vesting date of your Restricted Shares. (c) Committee Determinations. The Committee shall have absolute discretion to determine the date and circumstances of termination of your employment, and its determination shall be final, conclusive and binding upon you. 5. Change of Control Notwithstanding the provisions of paragraph 1, upon the occurrence of a Change of Control (as defined in the Employment Agreement, dated as of January 6, 2003, between the Company and you), all of the Restricted Shares for which the price hurdles have previously been achieved will vest immediately and any contractual holding period shall be waived if you are an employee of the Company or its subsidiaries at such time. 6. Income Tax Withholding You must make arrangements satisfactory to the Company to satisfy any applicable federal, state or local withholding tax liability arising with respect to the Restricted Shares. You can either make a cash payment to the Company of the required amount or, if you do not make a Section 83(b) election, you can elect to satisfy your withholding obligation by having the Company retain from your Restricted Shares Common Stock having a fair market value equal to the amount of your withholding obligation. If you fail to satisfy your withholding obligation in a time and manner satisfactory to the Company, the Company shall have the right to withhold the required amount from your Restricted Shares of Common Stock, salary or other amounts payable to you. Any election to have shares withheld must be made on or before the vesting date of your Restricted Shares. A copy of the withholding election form is attached. 7. Adjustment in Certain Events In the event of specified changes in the Company's capital structure, the Committee is required to make appropriate adjustment in the number and kind of shares authorized by the Plan, and the number and kind of shares covered by outstanding awards. This letter will continue to apply to your awards as so adjusted. 8. Effect on Other Benefits Income recognized by you as a result of the grant or vesting of Restricted Shares or the receipt of dividends on your Restricted Shares will not be included in the formula for calculating benefits under the Company's other benefit plans. 9. Stockholder Approval Notwithstanding anything to the contrary herein, in the event that an amendment to the Plan has not been approved by the Company's stockholders at or before the Company's next annual meeting of stockholders, the Restricted Shares granted hereby shall for all purposes be deemed to be contractually granted Restricted Shares with the same terms and conditions except that they shall not be deemed granted or subject to the Plan. * * * * * B-2 If you have any questions regarding your grant of Restricted Shares or would like to obtain additional information about the Plan or its administration, please contact the Company's Secretary, Factory 2-U Stores, Inc., 4000 Ruffin Road, San Diego, CA 92123-1866, (telephone (858) 627-1800). This letter contains the formal terms and conditions of your award and accordingly should be retained in your files for future reference. Very truly yours, FACTORY 2-U STORES, INC. /s/ William R. Fields William R. Fields Chairman & Chief Executive Officer ACCEPTED: /s/ Melvin Redman Melvin Redman B-3 WITHHOLDING ELECTION RESTRICTED SHARES GRANTED ON JANUARY 6, 2003 Instructions 1. You can use this election form if you would like to have some of your Restricted Shares retained by the Company when they vest and used to satisfy your tax withholding obligations. If you do not file this election with the Company's Secretary on or before the date your Restricted Shares vest, you must pay the Company the amount of your federal, state and local tax withholding obligation with respect to such Restricted Shares by cash or check at the time you recognize income with respect to such shares, or you must make other arrangements with the Company to satisfy this obligation. 2. DO NOT FILE THIS FORM IF YOU HAVE MADE AN ELECTION WITH RESPECT TO THESE SHARES UNDER SECTION 83(b) OF THE INTERNAL REVENUE CODE. 3. If you would like to have some of your shares used to satisfy tax withholding obligations, you should file this Withholding Election on or before the date your Restricted Shares vest. 4. You may amend this election at any time by filing a subsequently dated Withholding Election form with the Company's Secretary. Copies of this form may be obtained from the Company's Secretary. 5. Please call the Company's Secretary if you have questions about this Withholding Election form. B-4 WITHHOLDING ELECTION RESTRICTED SHARES GRANTED ON JANUARY 6, 2003 I hereby elect to have Factory 2-U Stores, Inc. retain a number of shares of Common Stock from the award granted to me under the Second Amended and Restated 1997 Stock Option Plan equal to the number of shares necessary to satisfy the Company's federal, state and local tax withholding obligation with respect to the vesting of such Shares. Signature Name (Print or Type) Date B-5 EX-10 6 exhempagtlk.txt EMPLOYMENT AGREEMENT LK Exhibit 10.15 EMPLOYMENT AGREEMENT THIS EMPLOYMENT AGREEMENT, dated as of January 6, 2003, by and between Factory 2-U Stores, Inc. (the "Company"), a Delaware corporation, and Larry I. Kelley, who currently resides in Duxbury, Massachusetts ("Executive"). W I T N E S S E T H WHEREAS, the Company desires to employ Executive, and Executive desires to accept such employment on the terms and conditions set forth in this Agreement. NOW, THEREFORE, in consideration of the promises and mutual covenants contained herein and for other good and valuable consideration, the Company and Executive agree as follows: 1. Term of Employment. Except upon earlier termination as provided in Section 9 hereof, Executive's employment under this Agreement shall be for a one-year term commencing on the date of this Agreement (the "Effective Date") and terminating on January 6, 2004; provided, however, that at the scheduled end of the employment term, and on each anniversary of such date, the employment term shall automatically be extended for a one-year period unless the Company or the Executive gives notice to the other at least 90 days before an extension is to take effect that they do not desire the employment term to be extended. The term of employment, as so extended from time to time, is referred to in this Agreement as the "Employment Term." 2. Positions. (a) Executive shall serve as Executive Vice President-Merchandising and Marketing of the Company. Executive shall report to the Chief Executive Officer of the Company ("CEO") and shall have such duties and authority, consistent with his position as Executive Vice President-Merchandising and Marketing of the Company, as shall be assigned to him from time to time by the CEO. (b) During the -Employment Term, Executive shall, without additional compensation, perform such executive and consulting services for, or on behalf of, such subsidiaries or affiliates of the Company as the CEO may, from time to time, request. The Company and such subsidiaries and affiliates are hereinafter referred to, collectively, as the "Company" and, individually, as a "Constituent Corporation." For purposes of this Agreement, the term "Affiliate" shall have the meaning given in the Securities Exchange Act of 1934, as amended (the "Act"). (c) During the Employment Term, Executive shall devote substantially all of his business time and efforts to the performance of his duties hereunder; provided, however, that Executive shall be permitted, to the extent that such activities do not materially interfere with the performance of his duties and responsibilities hereunder, to manage his personal financial and legal affairs and to serve on not more than three corporate, civic or charitable boards or committees. Notwithstanding the foregoing, the Executive shall not serve on any corporate board of directors or similar body if such service would be inconsistent with his fiduciary responsibilities to any Constituent Corporation and in no event shall Executive serve on any such board or other body unless approved by the CEO, which approval shall not be unreasonably withheld. Executive shall, within three months after the Effective Date, relocate his principal residence to a location not more than fifty (50) miles from the Company's executive offices in San Diego, California. 3. Base Salary. During the Employment Term, the Company shall pay to the Executive a base salary at the annual rate of not less than Four Hundred Thousand Dollars ($400,000). Base salary shall be payable in accordance with the usual payroll practices of the Company. Executive's base salary shall be subject to annual review by the CEO and may be increased, but not decreased, from time to time at the discretion of the CEO. The base salary, as determined as aforesaid from time to time, shall constitute "Base Salary" for purposes of this Agreement. 4. Annual Bonus. Not later than 30 days after the Effective Date, Executive shall prepare and present to the CEO written financial, operational and other objectives (the "Performance Objectives") for the Company's fiscal year ending February 3, 2004. If such Performance Objectives are approved and accepted by the CEO, Executiv's target bonus for such fiscal year shall be equal to 50% of Executive's annual Base Salary for such year. For each fiscal year during the Employment Term thereafter, Executive shall prepare and submit Performance Objectives to the CEO during the normal course of the Company's planning cycle and before the commencement of the new fiscal year. If such subsequent Performance Objectives are accepted and approved by the CEO, Executive's target bonus for such fiscal years shall be based on 50% of Executive's Base Salary in effect as of the start of such fiscal year. In the event of any disagreement between the CEO and Executive concerning the acceptance and approval of Performance Objectives, the CEO and Executive shall negotiate in good faith to attempt to resolve such differences. Annual bonuses shall be reduced pro rata for any fiscal year that is not a full year (based on the actual number of days of such year included in the Employment Term). Each annual bonus shall be paid no later than 30 days after the Company's audited financial statements with respect to the year for which the annual bonus is awarded are available. If the Performance Objectives accepted by the CEO are exceeded in any year, the annual bonus shall be increased by 1% of Base Salary for each 1% of excess, up to a maximum bonus of 100% of Base Salary for the achievement of 150% of the Performance Objectives. If the Performance Objectives accepted by the CEO are not met, the Executive shall not be entitled to any bonus. Anything to the contrary notwithstanding, Executive shall receive a minimum annual bonus of $100,000 for the fiscal year ending February 3, 2004, payable in 12 equal monthly installments beginning in February of 2003 in accordance with the Company's usual payroll practices so long as Executive remains employed by the Company, with such amount to be subtracted from any larger annual bonus to which Executive may become entitled for such fiscal year pursuant to this paragraph 4. 5. Equity Compensation. (a) Non-Qualified Stock Options. The Company will grant to Executive, pursuant to the Company's Second Amended and Restated 1997 Stock Option Plan (the "Plan"), if approved by the stockholders at the Company's next annual meeting of stockholders or, if such approval is not obtained, by contract not subject to the Plan, nonqualified options entitling Executive to acquire a total of 75,000 shares of the Company's common stock at the closing market price of such common stock on the commencement date of the Employment Term. Subject to Executive's continued employment under this Agreement, such nonqualified stock options will vest in increments of 4,687.50 shares (each, a "Tranche") on each March, June, September and December 30 during the first four years of the Employment Term. The non-qualified options in each such Tranche shall be exercisable for a period of five years after the vesting of such Tranche. During any period of time after one year from the date of this Agreement that shares acquired upon exercise of such non-qualified options would not be saleable by Executive pursuant to Rule 144 under the Act or pursuant to an effective registration statement under the Act, the Company shall file with the Securities and Exchange Commission and maintain the effectiveness of a registration statement on Form S-8 (or such successor or replacement form as may be applicable) to permit Executive to resell shares of common stock acquired upon exercise of such non-qualified stock options. The terms of such nonqualified stock options will be more specifically set forth in a Stock Option Agreement substantially in the form attached as Exhibit A. (b) Restricted Stock. The Company will grant to Executive pursuant to the Plan, if approved by the stockholders at the Company's next annual meeting of stockholders or, if such approval is not obtained, by contract not subject to the Plan, one hundred twenty-five thousand (75,000) restricted shares of the Company's common stock (the "Restricted Stock") at a cost to Executive of Seven Hundred Fifty Dollars ($750). (c) Vesting. The Restricted Stock shall vest in installments as follows: 25,000 shares of Restricted Stock shall vest at such time as the closing market price of the Company's common stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period; an additional 25,000 shares of restricted common stock shall vest at such time as the closing market price of the Company's common stock equals or exceeds twenty dollars ($20) per share for 20 consecutive trading days in any three-month period; and the final 25,000 shares of the Company's common stock shall vest at such time as the closing market price of the Company's common stock equals or exceeds thirty dollars ($30) per share for 20 consecutive trading days in any three-month period. Executive's right to receive any shares of Restricted Stock that have not so vested prior to January 6, 2008 shall terminate and any such Restricted Stock shall be retained by the Company. Notwithstanding the foregoing, Executive shall not be entitled to sell any such vested shares of Restricted Stock until the expiration of two years from the Effective Date (the "Holding Period"). The terms of such Restricted Stock will be more specifically set forth in a Restricted Stock Agreement substantially in the form attached as Exhibit B. (d) Restrictions on Restricted Stock. Until Restricted Stock has vested and the Holding Period has expired, it may not be sold, transferred, assigned or pledged. Shares of Restricted Stock shall be evidenced by stock certificates bearing appropriate legends referring to the applicable terms, conditions and restrictions. Stock certificates representing the Restricted Stock will be registered in the name of Executive as of the date of this Agreement, but such 2 certificates will be held by the Company until the shares vest and the Holding Period has expired, and Executive shall deliver to the Company a stock power, endorsed in blank, relating to the shares of Restricted Stock. At such time as Restricted Stock vests, and the expiration of the Holding Period with regard to such vested shares of Restricted Stock, a certificate representing such shares (less any shares retained by the Company to satisfy Executive's tax withholding obligations) will be delivered to Executive as soon as practicable. (e) Dividends and Voting. From and after the date of issuance of the Restricted Stock, Executive will have, with respect to the Restricted Stock, all the rights of a holder of common stock, including the right to receive any dividends or distributions paid on the common stock and the right to vote the shares of Restricted Stock. (f) Income Tax. Executive shall be required to make arrangements satisfactory to the Company to satisfy any applicable federal, state or local tax liability arising with respect to the Restricted Stock. Such arrangements may be satisfied by either making a cash payment to the Company of the required amount or by having the Company retain Restricted Stock having a value equal to the amount of Executive's federal, state and local tax obligation from the shares of Restricted Stock otherwise deliverable to Executive upon the vesting of such Restricted Stock and expiration of the Holding Period. If Executive fails to satisfy the obligations in a time and manner satisfactory to the Company, the Company may withhold all required amounts from Executive's compensation or other amounts payable under this Agreement to satisfy such federal, state and local tax obligations. Executive shall be solely responsible for determining whether to make, and for making, any election under Section 83(b) of the Internal Revenue Code of 1986 (as amended) with respect to the Restricted Stock. (g) Effect and Other Benefits. Income recognized by Executive as the result of the grant or vesting of Restricted Stock, the expiration of the Holding Period or the receipt of dividends, unrestricted stock will not be included in any formula for calculating benefits under this Agreement or any benefit plan of the Company. 6. Employment Benefits and Vacation. (a) During the Employment Term, Executive shall also be entitled to participate in all pension, retirement, savings, welfare and other pension and welfare employee benefit plans and arrangements and fringe benefits and perquisites generally maintained by the Company from time to time for the benefit of senior executives of the Company, in accordance with their respective terms as in effect from time to time (other than any special arrangement entered into by contract with an executive). (b) During the Employment Term, Executive shall be entitled to vacation each year in accordance with the Company's policies in effect from time to time, but in no event less than four (4) weeks paid vacation per calendar year. Executive shall also be entitled to such sick leave as is customarily provided by the Company for its senior executive employees. 7. Moving Expenses. The Company will reimburse Executive on an after-tax basis for all reasonable expenses incurred by the Executive (i) for the relocation of his family to San Diego for the purpose of commencing Executive's employment pursuant to this Agreement, including one customary real estate commission, (ii) for interim living expenses in the San Diego area reasonably incurred to maintain Executive's normal standard of living for up to 90 days and (iii) for up to two trips to the San Diego area for Executive and Executive's spouse for the purpose of locating a residence. In the event that Executive's employment is terminated by the Company without Cause or Executive terminates his employment with the Company for Good Reason, in each case within one year after the Effective Date, the Company will reimburse Executive for all reasonable expenses incurred by Executive in the relocation of his family to Duxbury, Massachusetts. 3 8. Business Expenses; Vehicle Allowance. (a) Executive shall be reimbursed for the travel, entertainment and other business expenses incurred in the performance of his duties hereunder, in accordance with policies generally applicable to senior executives of the Company as in effect from time to time. (b) During the Employment Term, the Company shall provide a vehicle allowance to Executive in the amount of $750.00 per month. 9. Termination. (a) The employment of Executive under this Agreement shall terminate on the expiration of the Employment Term and earlier upon the occurrence of any of the following events: (i) the death of Executive; (ii) the termination by the Company of Executive's employment due to Executive's Disability pursuant to Section 9(b) hereof; (iii) the termination by Executive of Executive's employment for Good Reason pursuant to Section 9(c) hereof; (iv) the termination by the Company of Executive's employment without Cause; (v) the termination by Executive of Executive's employment without Good Reason upon sixty (60) days prior written notice; or (vi) the termination by the Company of Executive's employment for Cause pursuant to Section 9(e) hereof. (b) Disability. If, by reason of the same or related physical or mental reasons, Executive is unable to carry out his material duties pursuant to this Agreement for more than three (3) months in any twelve (12) consecutive month period, the Company may terminate Executive's employment for Disability upon thirty (30) days prior written notice. (c) Termination for Good Reason. A Termination for Good Reason means a termination by Executive by written notice given within ninety (90) days after the occurrence of the Good Reason event. For purposes of this Agreement, "Good Reason" shall mean the occurrence or failure to cause the occurrence, as the case may be, without Executive's express written consent, of any of the following circumstances, unless such circumstances are corrected prior to the date of termination specified in the Notice of Termination for Good Reason (as defined in Section 9(d) hereof): (i) the material breach by the Company of any of its obligations to Executive under this Agreement; (ii) any material diminution of Executive's positions, duties or responsibilities hereunder, as of the Effective Date (except in each case in connection with the termination of Executive's employment for Cause or Disability or as a result of Executive's death, or temporarily as a result of Executive's illness or other absence and provided that a reduction in the size or number of the units reporting to Executive as a result of dispositions, shall not be a material diminution), or the assignment to Executive of duties or responsibilities that are inconsistent with Executive's position as the Executive Vice President-Merchandising and Marketing of the Company; (iii) removal of, or the nonreelection of, the Executive from his position as the Executive Vice President-Merchandising and Marketing of the Company; (iv) a relocation of the principal executive offices of the Company to a location more than seventy-five (75) miles from its current location in San Diego, California, or a relocation of Executive away from such principal executive office; (v) failure by the CEO and Executive to agree on Performance Objectives, after good faith negotiations, within 60 days after submission to the CEO by Executive; or (vi) any change in the Company's Certificate of Incorporation or Bylaws not approved by Executive that materially and adversely diminish Executive's rights to indemnification in his capacity as an officer or director of the Company. (d) Notice of Termination of Good Reason. A Notice of Termination for Good Reason shall mean a notice that shall indicate the specific termination provision in Section 9(c) relied upon and shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for Termination for Good Reason. The Notice of Termination for Good Reason shall provide for a date of termination not less than ten (10) nor more than sixty (60) days after the date such Notice of Termination for Good Reason is given. 4 (e) Cause. Subject to the notification provisions of Section 9(f) below, Executive's employment hereunder may be terminated by the Company for Cause. For purposes of this Agreement, the term "Cause" shall be limited to (i) willful misconduct by Executive with regard to the Company; (ii) the refusal of Executive to follow the proper written direction of the Board; provided, however, that the foregoing refusal shall not be "Cause" if Executive in good faith believes that such direction is illegal, unethical or immoral and promptly so notifies in writing the entity or person giving the direction; (iii) Executive being convicted of a felony; (iv) the willful breach by Executive of any fiduciary duty owed by Executive to any Constituent Corporation which has a material adverse effect on the Company; or (v) Executive's material fraud with regard to any Constituent Corporation. (f) Notice of Termination for Cause. A Notice of Termination for Cause shall mean a notice that shall indicate the specific termination provision in Section 9(e) relied upon and shall set forth in reasonable detail the facts and circumstances which provide a basis for Termination for Cause. The date of termination for a Termination for Cause shall be the date indicated in the Notice of Termination. Any purported Termination for Cause which is held by a court not to have been based on the grounds set forth in this Agreement shall be deemed a Termination without Cause. 10. Consequences of Termination of Employment. (a) Death. If Executive's employment is terminated during the Employment Term by reason of Executive's death, the employment period under this Agreement shall terminate without further obligations to the Executive's legal representatives under this Agreement except for (i) any compensation earned but not yet paid, including and without limitation, any declared but unpaid bonus, any amount of Base Salary or deferred compensation accrued or earned but unpaid, any accrued vacation pay payable pursuant to the Company's policies and any unreimbursed business expenses payable pursuant to Section 8, which amounts shall be promptly paid in a lump sum to Executive's estate; (ii) the product of (x) the target annual bonus for the fiscal year of Executive's death, multiplied by (y) a fraction, the numerator of which is the number of days of the current fiscal year during which Executive was employed by the Company, and the denominator of which is 365, which bonus shall be paid if and when bonuses for such period are paid to the other executive officers of the Company; (iii) subject to Section 11 hereof, any other amounts or benefits owing to Executive under the then applicable employee benefit plans or policies of the Company, which shall be paid in accordance with such plans or policies; and (iv) payment of the spouse's and dependent's COBRA coverage premiums to the extent, and as long as, they remain eligible for COBRA coverage, but in no event more than three (3) years. (b) Disability. If Executive's employment is terminated by reason of Executive's Disability, Executive shall be entitled to receive the payments and benefits to which his representatives would be entitled in the event of a termination of employment by reason of his death; provided that the payment of Base Salary shall be reduced by the projected amount he would receive under any long-term disability policy maintained by the Company or program maintained by the Company during the twelve (12) month period during which Base Salary is being paid. (c) Termination by Executive for Good Reason or for Change in Control. If (i) Executive terminates his employment hereunder for Good Reason during the Employment Term; or (ii) a Change in Control occurs and within 180 days thereafter Executive terminates his employment for any reason, Executive shall be entitled to receive the payments and benefits to which his representatives would be entitled in the event of a termination of employment by reason of his death plus payment on a monthly basis of twelve (12) months of Base Salary in effect as of the start of the fiscal year in which such termination occurs, in accordance with usual Company payroll practices. In addition, in the event Executive terminates his employment as a result of a Change of Control, Executive's non-qualified stock options shall immediately vest and become exercisable and Executive's Restricted Stock shall immediately vest. 5 (d) Termination With Cause or Voluntary Resignation Without Good Reason. If Executive's employment hereunder is terminated (i) by the Company for Cause; or (ii) by Executive without Good Reason except within 180 days following a Change in Control, the Executive shall be entitled to receive only his Base Salary through the date of termination, any earned but unpaid bonus for such year, any unreimbursed business expenses payable pursuant to Section 8 and any other benefits subject to Section 10(a)(iii) hereof to which he is entitled by law. All other benefits (including, without limitation, rights to retain Restricted Stock and rights to exercise options) due Executive shall terminate upon such termination of employment. (e) Non Renewal by the Company or Termination by the Company Without Cause. If this Agreement is not renewed by the Company at the end of the Employment Term or Executive's employment is terminated by the Company without cause, Executive shall be entitled to receive the payment and benefits to which his representatives would be entitled in the event of a termination of employment by reason of his death plus payment on a monthly basis of twelve (12) months of Base Salary in effect as of the start of such fiscal year, in equal shares all in accordance with usual Company payroll practices, subject to the execution, delivery and non-revocation by the Executive of a general release of claims in favor of the Company and its officers, directors, shareholders and affiliates in a form reasonably acceptable to the Company and the Executive. (f) Parachute Payments. Notwithstanding the foregoing, the benefits provided to the Executive under Section 10(c) on account of a Change in Control shall be reduced if and to the extent that a nationally recognized firm of compensation consultants or auditors designated by the Company determines that such reduction will result in a greater net after-tax benefit to the Executive than the Executive would obtain in the absence of such reduction, taking into account any excise tax payable by the Executive under Internal Revenue Code Section 4999. The allocation of the reduction required hereby among the benefits shall be determined by the Executive. 11. No Mitigation: No Set-Off. In the event of any termination of employment under Section 9, Executive shall be under no obligation to seek other employment and there shall be no offset against any amounts due Executive under this Agreement on account of any remuneration attributable to any subsequent employment that Executive may obtain. Any amounts due under Section 10 are in the nature of severance payments, or liquidated damages, or both, and are not in the nature of a penalty. Such amounts are inclusive and in lieu of any amounts payable under any other salary continuation or cash severance arrangement of the Company or any affiliate thereof and to the extent paid or provided under any other such arrangement shall be offset from the amount due hereunder. 12. Change in Control. Subject to the provisions of Section 12(b) hereof, for purposes of this Agreement, the term "Change in Control" shall mean (a) any "person" (as defined in the Act) not an affiliate of the Company on the Effective Date becomes the "beneficial owner" (as defined in Rule 13d-3 under the Act), directly or indirectly, of securities of the Company representing fifty percent (50%) or more of the combined voting power of the Company's then outstanding securities; (b) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board, and any new director (other than a director designated by a person who has entered into an agreement with the Company to effect a transaction described in this paragraph) whose election by the Board of the Company or nomination for election by the Company's stockholders was approved by a vote of at least two-thirds of the directors then still in office who either were directors at the beginning of the two-year period or whose election or nomination for election was previously so approved, cease for any reason to constitute at least a majority of the Board; (c) the stockholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) more than fifty percent (50%) of the combined voting power of the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation; or (d) the stockholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of all or substantially all of the Company's assets other than the sale of all or substantially all of the assets of the Company to a person or persons who beneficially own, directly or indirectly, at least fifty percent (50%) or more of the combined voting power of the outstanding voting securities of the Company at the time of the sale. 6 13. Confidential Information, Non-Competition and Non-Solicitation of the Company. (a) (i) Executive acknowledges that, as a result of his employment hereunder, Executive will obtain secret and confidential information of the Company and the Company will suffer substantial damage, which would be difficult to ascertain and in an amount which would be difficult to compute, if Executive should use any of such confidential information and that because of the nature of the information that will be known to Executive, it is necessary for the Company to be protected by the prohibition against Competition as set forth herein, as well as the Confidentiality restrictions set forth herein. (ii) Executive acknowledges that the retention of non-clerical employees of the Company, in which the Company has invested training and on which the Company depends for the operation of its business, is important to the businesses of the Company; Executive will obtain unique information as to such employees as an executive of the Company and will develop a unique relationship with such persons as a result of being an executive of the Company; and, therefore, it is necessary for the Company to be protected from Executive's Solicitation of such employees as set forth below. (iii) Executive acknowledges that the provisions of this Agreement are reasonable and necessary for the protection of the business of the Company and that part of the compensation paid under this Agreement and the agreement to pay severance in certain instances is in consideration for the agreements in this Section 13. (b) As used herein, "Competition" shall mean: participating, directly or indirectly, as an individual proprietor, partner, stockholder, officer, employee, director, joint venturer, investor, lender, consultant or in any capacity whatsoever (within the United States of America, or in any other country where any Constituent Corporation does business) in a business that owns or operates off price apparel and housewares stores (or any other business in which any Constituent Corporation is then engaged); provided, however, that such participation shall not include (i) the ownership of not more than one percent (1%) of the total outstanding stock of a publicly-held company; or (ii) any activity engaged in with the prior written approval of the Board. (c) As used herein, "Solicitation" shall mean recruiting, soliciting or inducing any non-clerical employee of any Constituent Corporation to terminate his or her employment with, or otherwise cease his or her relationship with, such Constituent Corporation or hiring, or assisting another person or entity to hire, any non-clerical employee of any Constituent Corporation or any person who, within six (6) months before, had been a non-clerical employee of any Constituent Corporation, unless the employment of such person by a Constituent Corporation was terminated involuntarily and without cause. (d) If any restriction set forth with regard to Competition or Solicitation is found by any court of competent jurisdiction, or an arbitrator, to be unenforceable because it extends for too long a period of time or over too great a range of activities or in too broad a geographical area, it shall be interpreted to extend over the maximum period of time, range of activities or geographic area as to which it may be enforceable. If any provision of this Section 13 shall be declared to be invalid or enforceable, in whole or in part, as a result of the foregoing, as a result of public policy or for any other reason, such invalidity shall not affect the remaining provisions of this Section, which shall remain in full force and effect. (e) During and after the Employment Term, Executive shall hold in a fiduciary capacity for the benefit of the Company all secret or confidential information, knowledge or data relating to the Company and its business, including any confidential information as to suppliers (i) obtained by Executive during his employment by the Company and (ii) not otherwise in the public domain. Executive shall not, without prior written consent of the Company, unless compelled pursuant to the order of a court or other government or legal body having jurisdiction over such matter, communicate or divulge any such information, knowledge or data to anyone other than the Company, and those designated by it. In the event Executive is compelled by order of a court or other governmental or legal body to communicate or divulge any such information, knowledge or data to anyone other than the foregoing, he shall promptly notify the Company of any such order and he shall cooperate fully with the Company in protecting such information to the full extent, possible under applicable law. 7 (f) Upon termination of his employment with the Company, or at any time the Company may request, Executive will promptly deliver to the Company, as requested, all documents (whether prepared by the Company, Executive or a third party) relating to the Company or any of its business or property which he may possess or have under his direction or control, other than his personal employment and personnel records. (g) During the Employment Term and for one (1) year thereafter, Executive will not enter into Competition with the Company; provided, however, that Executive's obligation under this sentence shall be suspended during any time when the Company is in breach of any payment obligation under Section 10(c) or 10(e) of this Agreement. Furthermore, in the event of any termination of Executive's employment for any reason whatsoever, whether by the Company or by the Executive and whether or not for Cause, Good Reason or expiration of the Employment Tem, the Executive will not engage in Solicitation for one (1) year thereafter. (h) Executive acknowledges that in the event of a breach of this Section 13, the Company will be caused irreparable injury and money damages may not be an adequate remedy. Consequently, Executive agrees that the Company shall be entitled to seek injunctive relief (in addition to its other remedies at law) to have the provisions of this Section 13 enforced. 14. Indemnification. (a) The Company agrees that if Executive is made a party to or threatened to be made a party to any action, suit or proceeding, whether civil, criminal, administrative or investigative (a "Proceeding"), by reason of the fact that he is or was a director or officer of any Constituent Corporation or is or was serving at the request of any Constituent Corporation as a director, officer, member, employee, fiduciary or agent of another corporation or of a partnership, joint venture, trust or other enterprise, including, without limitation, service with respect to employee benefit plans, whether or not the basis of such Proceeding is alleged action in an official capacity as a director, officer, member, employee, fiduciary or agent while serving as a director, officer, member, employee, fiduciary or agent, he shall be indemnified and held harmless by the applicable company to the fullest extent authorized by applicable law against all Expenses incurred or suffered by Executive in connection therewith, and such indemnification shall continue as to Executive even if Executive has ceased to be an officer, director, member, fiduciary or agent, or is no longer employed by such company, and shall inure to the benefit of his heirs, executors and administrators. (b) As used in this Agreement, the term "Expenses" shall include, without limitation, damages, losses, judgments, liabilities, fines, penalties, excise taxes, settlements and costs, attorneys' fees, accountants' fees and disbursements and costs of attachment or similar bonds, investigations and any expenses of establishing a right to indemnification under this Agreement. (c) To the extent permitted by applicable law, Expenses incurred by Executive in connection with any Proceeding shall be paid in advance upon request of Executive and the giving by the Executive of any undertakings required by applicable law. (d) Executive shall give the Company notice of any claim made against him for which indemnity will or could be sought under this Agreement. In addition, Executive shall give the Company such information and cooperation as it may reasonably require and as shall be within Executive's power and at such times and places as are reasonably convenient for Executive. 8 (e) With respect to any Proceeding involving Executive: (i) The Company will be entitled to participate therein at its own expense; and (ii) Except as otherwise provided below, to the extent that it may wish, the Company will be entitled to assume the defense thereof, with counsel reasonably satisfactory to Executive, in which case Executive also shall have the right to participate and employ his own counsel in such action, suit or proceeding, but only at his own cost and expense, provided that the Company shall only be permitted to assume defense of a Proceeding if (l) the Proceeding could not result in imposition of criminal penalties against Executive and (2) the Company acknowledges that it is liable to indemnify Executive with respect to all Expenses with respect to such Proceedings, except as provided earlier in this sentence with regard to Executive's own counsel. (f) The Company shall not be liable to indemnify Executive under this Agreement for any amounts paid in settlement of any action or claim effected without its written consent. The Company shall not settle any action or claim in any manner which would impose any penalty on Executive (except a penalty in respect of which Executive is fully indemnified hereunder) without Executive's written consent. Neither the Company nor Executive will unreasonably withhold or delay consent to any proposed settlement. (g) The right to indemnification and the payment of expenses incurred in defending a Proceeding in advance of its final disposition conferred in this Section 14 shall not be exclusive of any other right which Executive may have or hereafter may acquire under any statute, provision of the certificate of incorporation or by-laws of the Company, agreements, vote of stockholders or disinterested directors or otherwise. (h) The Company shall obtain officer and director liability insurance policies covering Executive in the same aggregate amount and under the same terms as are currently maintained by the Company for senior officers and directors and use commercially reasonable efforts to maintain such policies or replacement policies with substantially the same limits in effect during the term of Executive's employment by the Company. 15. Miscellaneous. (a) Entire Arrangement/Amendments. This Agreement and the instruments contemplated herein, contain the entire understanding of the parties with respect to the employment of Executive by the Company. There are no restrictions, agreements, promises, warranties, covenants or undertakings between the parties with respect to the subject matter hereof other than those expressly set forth herein and therein. This Agreement may not be altered, modified or amended except by written instrument signed by the parties hereto. (b) No Waiver. The failure of a party to insist upon strict adherence to any term of this Agreement on any occasion shall not be considered a waiver of such party's rights or deprive such party of the right thereafter to insist upon strict adherence to that term or any other term of this Agreement. Any such waiver must be in writing and signed by Executive or an authorized officer of the Company, as the case may be. 9 (c) Assignment. This Agreement shall not be assignable by Executive. This Agreement shall be assignable by the Company, but only to another Constituent Corporation and only if such Constituent Corporation promptly assumes all of the obligations hereunder of the Company in a writing delivered to the Executive and otherwise complies with the provisions hereof with regard to such assumption. Upon such assignment and assumption, all obligations of the Company herein shall be the obligations of the assignee entity or acquiror, as the case may be, but the Company shall remain secondarily liable for the obligations hereunder. (d) Successors; Binding Agreement. This Agreement shall inure to the benefit of and be binding upon the personal or legal representatives, executors, administrators, successor, heirs, distributees, devisees legatees and permitted assignees of the parties hereto. (e) Communications. For the purpose of this Agreement, notices and all other communications provided for in this Agreement shall be in writing and shall be deemed to have been duly given (i) when faxed or delivered in person; or (ii) two business days after mailed by United States registered or certified mail, return receipt requested, postage prepaid, addressed to the respective addresses set forth on the signature page of this Agreement, provided that all notices to the Company shall be directed to the CEO of the Company or to such other address as any party may have furnished to the other in writing in accordance herewith. Notice of change of address shall be effective only upon receipt. (f) Withholding Taxes. The Company may withhold from any and all amounts payable under this Agreement to Executive such Federal, state and local taxes as may be required to be withheld pursuant to any applicable law or regulation. (g) Survival. The respective rights and obligations of the parties hereunder shall survive any termination of Executive's employment to the extent necessary to the agreed preservation of such rights and obligations. (h) Counterparts. This Agreement may be signed in counterparts, each of which shall be an original, with the same effect as if the signatures thereto and hereto were upon the same instrument. (i) Headings. The headings of the sections contained in this Agreement are for convenience only and shall not be deemed to control or affect the meaning or construction of any provisions of this Agreement. (j) Notwithstanding anything to the contrary in this Agreement, the Company shall not be required to take any action or make any payment to the extent such action or payment would be inconsistent with or violate the provisions of the Sarbanes-Oxley Act of 2002. 10 IN WITNESS WHEREOF, the parties hereto have duly executed this Agreement as of the day and year first above written, FACTORY 2-U STORES, INC. By: /s/ William R. Fields William R. Fields, Chief Executive Officer Address: 4000 Ruffin Road San Diego, California 92123-1866 Telephone: (858) 627-1800 Fax: (858) 637-4199 /s/ Larry I. Kelley Larry I. Kelley Address: 4000 Ruffin Road San Diego, California 92123-1866 Telephone: (858) 442-9009 Fax: (858) 576-4506 11 Exhibit A FACTORY 2 - U STORES, INC. NONQUALIFIED STOCK OPTION AGREEMENT No. of Shares: 75,000 Date: January 6, 2003 This is to confirm that Factory 2-U Stores, Inc. ("Factory 2-U") has granted Larry Kelley ("you") a nonqualified stock option under Factory 2-U's Second Amended and Restated 1997 Stock Option Plan (the "Plan") to purchase up to 75,000 shares (the "Option Shares") of common stock, par value $0.01 per share, of Factory 2-U, on the following principal terms: 1. When Option can be Exercised. Subject to your continued employment under that certain Employment Agreement (the "Employment Agreement") between Factory 2-U and you of even date herewith, the Option will vest in increments with respect to 4,687.50 shares (each, a "Tranche") on each March, June, September and December 30 during the first four years of the Employment Term (as defined in the Employment Agreement). The Option with respect to each such Tranche shall be exercisable for a period of five years after the vesting of such Tranche. The Option may also terminate as described in Paragraph 4 or as described in the Plan. Under some circumstances described below or described in the Plan, the Option will become exercisable in full, even before the date stated in the first sentence to be the earliest date on which the Option may be exercised. 2. Exercise Price. The price which must be paid for Option Shares if the Option is exercised will be $3.13 per share. However, that exercise price may be adjusted as provided in the Plan to take account of certain types of corporate actions, such as stock dividends, stock splits, share combinations, recapitalizations or reorganizations. The exercise price must be paid by certified check or by tendering shares of Factory 2-U common stock with a market value on the day those shares are tendered (based on the last reported sale price of Factory 2-U common stock on that day) equal to the exercise price. 3. How to Exercise the Option. To exercise the Option, you must give a written notice of the exercise to Factory 2-U at its principal executive office, to the attention of its Secretary, accompanied by payment of the exercise price by certified check or by a tender of shares. A suggested form of notice of exercise is attached to this Agreement. The Option will be deemed exercised when Factory 2-U receives the notice of exercise accompanied by payment of the exercise price in cash or by tender of shares. A certificate for the number of shares as to which the Option is exercised will be sent to you as soon as practicable after the day on which the Option is exercised. That certificate may bear a legend stating that the shares represented by it have not been registered under the Securities Act of 1933, as amended, and may be sold or transferred only in a transaction which is registered under that Act or is exempt from the registration requirements of that Act. 4. Termination under Some Circumstances. If you cease to be employed by Factory 2-U or a subsidiary: (a) if the reason your employment terminates is your death or total disability, the Option will expire at the end of the 12 month period following the day on which your employment terminates; (b) if the reason your employment terminates is your retirement after you reach the age of 65, your voluntary resignation with the consent of Factory 2-U (which Factory 2-U will be under no obligation to give) or the termination of your employment by Factory 2-U other than for Cause (as defined in the Employment Agreement), the Option will expire at the end of the three month period following the day on which your employment terminates; and (c) if your employment terminates other than for a reason described in subparagraph (a) or (b), the Option will expire on the day on which your employment terminates. 5. Change of Control. In the event of a Change of Control, as defined in the Employment Agreement, the Options shall immediately vest and become exercisable. 6. Prohibition against Assignments. During your lifetime, the Option may be exercised only by you, or by your guardian or legal representative, if you become unable to act. After your death, the Option may be exercised by the executor of your estate or your other personal representative, or by the persons to whom the right to exercise the Option has passed under your will or through the laws of descent and distribution. The Option may not be assigned, pledged or hypothecated in any way, may not be subject to execution by a creditor or any other person and may not be transferred other than by will or the laws of descent and distribution. Any attempted assignment, transfer, pledge, hypothecation or other disposition of the Option which is not specifically permitted by the Plan will be void. 7. Not a Stockholder. You will have no rights as a stockholder of Factory 2-U because of the Option until you exercise the Option and receive shares as a result of the exercise. 8. No Guarantee of Employment. The fact that you have been granted an Option will not give you any right to continue in the employ of Factory 2-U or a subsidiary, and will not interfere with or restrict any right Factory 2-U or a subsidiary may have to discharge you as an employee, or any right you have under an employment contract or otherwise to continue to be employed by Factory 2-U or a subsidiary. 9. Compliance with Securities Laws. Factory 2-U's obligation to issue shares to you upon exercise of the Option is subject to the condition that the issuance of the shares will be in compliance with the Securities Act of 1933, as amended, and all other applicable laws and regulations, and that the stock you will be purchasing by exercising the Option will be authorized for listing on any securities exchange on which Factory 2-U's common stock may in the future be listed. 10. Withholding of Taxes. If Factory 2-U is required to pay withholding tax because of your exercise of the Option, you may direct Factory 2-U to (i) withhold shares you purchase by exercising the Option or Restricted Shares granted pursuant to your Employment Agreement that have vested as of such time, (ii) require you to pay Factory 2-U a sum equal to the sum Factory 2-U must withhold before Factory 2-U will issue stock to you as a result of your exercising the Option or (iii) deduct the sum which must be withheld from one or more installments of your compensation. If you fail to so direct Factory 2-U, Factory 2-U may elect any such alternatives. If you make an election under Section 83(b) of the Internal Revenue Code in connection with your exercise of the Option, you must notify Factory 2-U of that fact. 11. Plan Controls. If there is any inconsistency between the terms of the Plan and the terms of this Agreement, the terms of the Plan will control. The Committee which administers the Plan will have authority to interpret the Plan and this Agreement. 12. Stockholder Approval. Notwithstanding anything to the contrary herein, in the event that an amendment to the Plan has not been approved by the Company's stockholders at or before the Company's next annual meeting of stockholders, the Option granted hereby shall for all purposes be deemed to be a contractual nonqualified stock option with the same terms and conditions except that it shall not be deemed granted under or subject to the Plan. A-2 13. Amendments. The Board of Directors of Factory 2-U may at any time modify or amend the Plan. However, no modification or amendment of the Plan will affect your rights as the holder of this Option without your consent. FACTORY 2-U STORES, INC. By: /s/ William R. Fields William R. Fields Chairman & Chief Executive Officer ACCEPTED: /s/ Larry Kelley Larry Kelley A-3 NOTICE OF EXERCISE Secretary Factory 2-U Stores, Inc. 4000 Ruffin Road San Diego, CA 92123 Dear Sir or Madam: This is to notify you that I am exercising the Option, dated January 6, 2003 granted to me under the Factory 2-U Stores, Inc. Second Amended and Restated 1997 Stock Option with regard to __________ shares of Common Stock. The exercise price specified in my Option Agreement is $3.13 per share. In order to pay the exercise price, I: enclose a certified check in the amount enclose certificates representing shares of Factory 2-U common stock with a fair market value on the date of this Notice (based upon the last reported sale price of Factory 2-U common stock on the date of this Notice) equal to the exercise price for all the shares as to which I am exercising this Option. Dated: _______________ Very truly yours, (Print Name) (Signature) (Social Security Number) A-4 Exhibit B FACTORY 2-U STORES, INC. RESTRICTED STOCK AGREEMENT January 6, 2003 Larry Kelley c/o Factory 2-U Stores, Inc. 4000 Ruffin Road San Diego, California 92123-1866 Dear Larry: This letter sets forth the terms and conditions of the shares of restricted stock granted to you by Factory 2-U Stores, Inc. (the "Company"), in accordance with the provisions of its Second Amended and Restated 1997 Stock Option Plan (the "Plan"). You have been granted 75,000 restricted shares (the "Restricted Shares") of the Company's Common Stock ("Common Stock"). Your Restricted Shares are subject to the terms and conditions set forth in the Plan, any rules and regulations adopted by the Compensation committee of the Board of Directors (the "Committee") and this letter. Any terms used in this letter and not defined have the meanings set forth in the Plan. 1. Vesting of Restricted Shares (a) Unless they vest on an earlier date as provided in paragraphs 4 and 5 below, your Restricted Shares will vest in installments as follows, provided that you are an employee of the Company or its subsidiaries on each such date: 25,000 Restricted Shares shall vest at such time as the closing market price of the Common Stock equals or exceeds $10 per share for 20 consecutive trading days in any three-month period; an additional 25,000 Restricted Shares shall vest at such time as the closing market price of the Common Stock equals or exceeds twenty dollars ($20) per share for 20 consecutive trading days in any three-month period; and the final 25,000 Restricted Shares shall vest at such time as the closing market price of the Common Stock equals or exceeds thirty dollars ($30) per share for 20 consecutive trading days in any three-month period. Your right to receive any Restricted Shares that have not so vested prior to January 6, 2008 shall terminate and any such Restricted Shares shall be retained by the Company. Notwithstanding the foregoing, you shall not be entitled to sell any such vested Restricted Shares until the expiration of two years from the date hereof (the "Holding Period"). (b) You must pay Seven Hundred Fifty Dollars ($750) to receive the Restricted Shares granted to you by this letter. 2. Restrictions on the Restricted Shares Until Restricted Shares have vested and the Holding Period has expired, they may not be sold, transferred, assigned or pledged. Restricted Shares shall be evidenced by stock certificates bearing appropriate legends referring to the applicable terms, conditions and restrictions. Stock certificates representing the Restricted Shares will be registered in your name as of the date hereof, but such certificates will be held by the Company until the Restricted Shares vest and the Holding Period has expired, and you shall deliver to the Company a stock power, endorsed in blank, relating to the Restricted Shares. At such time as Restricted Shares vest, and the expiration of the Holding Period with regard to such vested shares, a certificate representing such shares (less any shares retained by the Company to satisfy Executive's tax withholding obligations) will be delivered to Executive as soon as practicable. 3. Dividends and Voting From the date of this letter, you will receive, with respect to your Restricted Shares, payments equal to the amount of dividends paid on Common Stock. Such payments will be paid directly to you at the same time dividends are paid with respect to all other shares of Common Stock. You will have the right to vote your Restricted Shares. 4. Termination of Employment (a) General. If your employment terminates for any reason, any of your Restricted Shares which have not vested prior to your termination of employment will be forfeited. (b) Acceleration of Vesting. The Committee may, in its discretion, declare all or any portion of your Restricted Shares immediately vested or otherwise accelerate the vesting date of your Restricted Shares. (c) Committee Determinations. The Committee shall have absolute discretion to determine the date and circumstances of termination of your employment, and its determination shall be final, conclusive and binding upon you. 5. Change of Control Notwithstanding the provisions of paragraph 1, upon the occurrence of a Change of Control (as defined in the Employment Agreement, dated as of January 6, 2003, between the Company and you), all of the Restricted Shares for which the price hurdles have previously been achieved will vest immediately and any contractual holding period shall be waived if you are an employee of the Company or its subsidiaries at such time. 6. Income Tax Withholding You must make arrangements satisfactory to the Company to satisfy any applicable federal, state or local withholding tax liability arising with respect to the Restricted Shares. You can either make a cash payment to the Company of the required amount or, if you do not make a Section 83(b) election, you can elect to satisfy your withholding obligation by having the Company retain from your Restricted Shares Common Stock having a fair market value equal to the amount of your withholding obligation. If you fail to satisfy your withholding obligation in a time and manner satisfactory to the Company, the Company shall have the right to withhold the required amount from your Restricted Shares of Common Stock, salary or other amounts payable to you. Any election to have shares withheld must be made on or before the vesting date of your Restricted Shares. A copy of the withholding election form is attached. 7. Adjustment in Certain Events In the event of specified changes in the Company's capital structure, the Committee is required to make appropriate adjustment in the number and kind of shares authorized by the Plan, and the number and kind of shares covered by outstanding awards. This letter will continue to apply to your awards as so adjusted. 8. Effect on Other Benefits Income recognized by you as a result of the grant or vesting of Restricted Shares or the receipt of dividends on your Restricted Shares will not be included in the formula for calculating benefits under the Company's other benefit plans. 9. Stockholder Approval Notwithstanding anything to the contrary herein, in the event that an amendment to the Plan has not been approved by the Company's stockholders at or before the Company's next annual meeting of stockholders, the Restricted Shares granted hereby shall for all purposes be deemed to be contractually granted Restricted Shares with the same terms and conditions except that they shall not be deemed granted or subject to the Plan. * * * * * B-2 If you have any questions regarding your grant of Restricted Shares or would like to obtain additional information about the Plan or its administration, please contact the Company's Secretary, Factory 2-U Stores, Inc., 4000 Ruffin Road, San Diego, CA 92123-1866, (telephone (858) 627-1800). This letter contains the formal terms and conditions of your award and accordingly should be retained in your files for future reference. Very truly yours, FACTORY 2-U STORES, INC. /s/ William R. Fields William R. Fields Chairman & Chief Executive Officer ACCEPTED: /s/ Larry Kelley Larry Kelley B-3 WITHHOLDING ELECTION RESTRICTED SHARES GRANTED ON JANUARY 6, 2003 Instructions 1. You can use this election form if you would like to have some of your Restricted Shares retained by the Company when they vest and used to satisfy your tax withholding obligations. If you do not file this election with the Company's Secretary on or before the date your Restricted Shares vest, you must pay the Company the amount of your federal, state and local tax withholding obligation with respect to such Restricted Shares by cash or check at the time you recognize income with respect to such shares, or you must make other arrangements with the Company to satisfy this obligation. 2. DO NOT FILE THIS FORM IF YOU HAVE MADE AN ELECTION WITH RESPECT TO THESE SHARES UNDER SECTION 83(b) OF THE INTERNAL REVENUE CODE. 3. If you would like to have some of your shares used to satisfy tax withholding obligations, you should file this Withholding Election on or before the date your Restricted Shares vest. 4. You may amend this election at any time by filing a subsequently dated Withholding Election form with the Company's Secretary. Copies of this form may be obtained from the Company's Secretary. 5. Please call the Company's Secretary if you have questions about this Withholding Election form. B-4 WITHHOLDING ELECTION RESTRICTED SHARES GRANTED ON JANUARY 6, 2003 I hereby elect to have Factory 2-U Stores, Inc. retain a number of shares of Common Stock from the award granted to me under the Second Amended and Restated 1997 Stock Option Plan equal to the number of shares necessary to satisfy the Company's federal, state and local tax withholding obligation with respect to the vesting of such Shares. Signature Name (Print or Type) Date B-5 EX-10 7 exhotaylease.txt OTAY MESA DC LEASE AGREEMENT Exhibit 10.16 INDUSTRIAL/COMMERCIAL SINGLE-TENANT LEASE - NET 1. Basic Provisions ("Basic Provisions"). 1.1 Parties. This Lease ("Lease"), dated March 8, 2002 ("Effective Date"), is made by and between ORIX Otay, LLC, an Illinois limited liability company ("Landlord") and FACTORY 2-U STORES, INC., a Delaware corporation ("Tenant") (collectively the "Parties," or individually a "Party"). 1.2 Premises; Land; Improvements. For purposes of this Lease, the "Premises" shall mean, collectively: (i) the "Land," which for purposes hereof shall mean that certain real property more particularly described on Exhibit "A" attached hereto, containing approximately 31.32 acres of area, located in the Otay Mesa area in the City of San Diego, County of San Diego, State of California; (ii) the "Improvements" (as defined in the Work Letter attached hereto as Exhibit "B" (the "Work Letter")), which includes that certain 1-story concrete tilt-up warehouse/distribution building containing approximately 600,000 rentable square feet to be constructed by Landlord on the Land under the terms of this Lease (the "Building"), all parking areas, driveways and entrances and exits to public streets and landscaped areas located on the Land, and (iii) all easements and other public and private rights now or hereafter appurtenant to the Land and the Improvements. 1.3 Lease Term. The initial term of this Lease (the "Original Term") shall be for twelve (12) years and three (3) months, commencing on the Commencement Date, as that term is defined in Paragraph 3, below, and ending on the last day of the calendar month in which the date which is one hundred forty-seven (147) months thereafter falls, subject to early termination as provided in this Lease or extension pursuant to Paragraph 47 below (the "Expiration Date"). In the event that Tenant elects to extend the Original Term by exercising one or more of the Options to Extend (defined in Paragraph 47.1 below), the Expiration Date shall mean the last day of the final exercised Option Term (defined in Paragraph 47.1 below) subject to early termination as provided in this Lease. The Original Term and any Option Term (which results from Tenant's exercise of an Option to Extend pursuant to Paragraph 47 below) are collectively referred to herein as the "Lease Term" or the "Term." 1.4 Base Rent. --------- (a) Base Rent. The monthly base rent ("Base Rent") payable by Tenant under this Lease during the Original Term shall be as set forth below in this Paragraph 1.4(a) for the Lease Months (as defined in Paragraph 1.4(b) below) during the Original Term. The Base Rent shall be payable on or before the first day of each calendar month during the Lease Term in accordance with the requirements of Paragraph 4. Lease Months During Original Term Monthly Installment of Base Rent - ------------------- -------------------------------- 1-3 "Early Occupancy Period" (defined in Paragraph 4.3 below). 4-63 The product of (i) 0.105 (the "Base Rent Factor") and (ii)one-twelfth (1/12) of the Improvement Costs (as defined in the Work Letter)(each such monthly installment is referred to herein as "First Period Monthly Base Rent"). Based upon the initial pro forma budget for Improvements Costs, the initial pro forma First Period Monthly Base Rent shall be $214,375.00 per month (the "Pro Forma First Period Monthly Base Rent"), which Pro Forma First Period Monthly Base Rent shall be subject to adjustment pursuant to Section 2.3 of the Work Letter. 64-123 The sum of (i) First Period Monthly Base Rent and (ii) an amount equal to twelve and one-half percent (12 1/2%) of the First Period Monthly Base Rent (collectively "Second Period Monthly Base Rent"). 124-Last The sum of (i) the Second Period Monthly Base Rent and (ii) an amount equal to eleven and three-quarters percent (11-3/4%) of the Second Period Monthly Base Rent. (b) The term "Lease Month(s)" shall mean each calendar month during the Lease Term subject to proration, if applicable, in accordance with Paragraph 4.2 below. 1.5 Intentionally Omitted. 1.6 Letter of Credit. (a) Pursuant to Paragraph 5 below, (i) concurrently with the delivery by Landlord to Escrow Holder of the Additional Deposit and the Due Diligence Approval (each defined in the Purchase Agreement (defined in the Work Letter)) and delivery to Tenant in cash of an amount equal to the Reimbursed Costs (defined below) pursuant to Paragraph 2.2.4(d), Tenant shall deliver to Landlord an original irrevocable letter of credit in the amount of One Million Dollars ($1,000,000.00) and otherwise conforming to the requirements of Paragraph 5 applicable to the Pre-Closing LC (the "Pre-Closing LC"). (b) On or before the Closing Date (defined in the Purchase Agreement), Tenant shall cause to be issued to Landlord an additional irrevocable letter of credit (in substitution for the Pre-Closing LC) in the amount of the LC Amount (defined in Paragraph 5.1(c) below) (the "Primary LC") and otherwise conforming to the requirements of Paragraph 5 applicable to the Primary LC; provided, however, that as a condition of Tenant's obligation to deliver the Primary LC to Landlord, concurrently with such delivery, Landlord shall return the Pre-Closing LC to Tenant. 1.7 Agreed Use. The Premises shall be used for warehouse, distribution, light manufacturing and office uses and all legally permitted uses incidental thereto (the "Agreed Use"). 1.8 Broker. The following real estate broker and brokerage relationship exist in this transaction. The Staubach Company represents Tenant exclusively as Tenant's real estate broker (the "Broker"), and no other brokerage relationship exists in this transaction (See Paragraph 15(b). 2 1.9 Addresses for Notices. The addresses for notices of the Parties under this Lease shall be as follows: (a) If to Landlord: ORIX Otay, LLC c/o ORIX Real Estate Equities, Inc. 100 North Riverside Plaza Suite 1400 Chicago, Illinois 60606 (b) If to Tenant: Factory 2-U Stores, Inc. 4000 Ruffin Road San Diego, California 92123 Fax No.: (858) 637-4180 Attention: President At all times with a copy to: Factory 2-U Stores, Inc. 4000 Ruffin Road San Diego, California 92123 Fax No.: (858) 637-4188 Attention: General Counsel At all times with a copy to: Paul, Hastings, Janofsky & Walker, LLP 555 S. Flower Street, 23rd Floor Los Angeles, California 90071 Fax No.: (213) 627-0705 Attention: Patrick A. Ramsey, Esq. 1.10 Exhibits and Riders. Attached hereto are Exhibits "A," "B," "C," "D," "E," "F," and "G" all of which constitute a part of this Lease. 2. Premises. 2.1 Letting. Subject only to (i) its acquisition of the Land pursuant to the provisions of the Purchase Agreement (defined in the Work Letter), and (ii) the terms, covenants and conditions of this Lease, (a) Landlord hereby leases to Tenant, and Tenant hereby leases from Landlord, the Premises, for the Lease Term, at the rental, and upon (and subject to) all of the terms, covenants and conditions set forth in this Lease, and (b) Landlord agrees to cause the Improvements to be constructed pursuant to the terms of the Work Letter and (c) except as otherwise expressly provided for in the Work Letter or in this Lease, Landlord shall not be obligated to make any repairs, replacements or improvements (whether structural or otherwise) of any kind or nature to the Premises in connection with, or in consideration of, this Lease. 2.2 Development of the Premises. 2.2.1 Acquisition of the Land. (a) Tenant and Sunroad Otay Partners, L.P. are the purchaser and seller ("Seller"), respectively, under the Purchase Agreement (defined in the Work Letter). Pursuant to Paragraph 19 of the Purchase Agreement, Tenant is permitted to assign each and all of its rights and obligations under the Purchase Agreement to Landlord (without the consent of the Seller under the Purchase Agreement) at any time following delivery to Seller of a fully executed copy of this Lease. (b) Promptly following full execution of this Lease by Landlord and Tenant (and concurrently with Landlord's delivery to Escrow Holder of the Approval Notice (defined in the Purchase Agreement) and Landlord's delivery to Tenant of the Reimbursed Costs pursuant to Paragraph 2.2.4(d)), Landlord and Tenant shall execute and deliver to Seller (and to one another) an original counterpart of the Assignment of Purchase Agreement (defined in the Work Letter) (and shall deliver to Seller a copy of this Lease), and Tenant shall deliver to Landlord the Pre-Closing LC pursuant to Paragraph 1.6(a) of this Lease. 3 (c) Landlord shall use its commercially reasonable good faith efforts (which is a material inducement for Tenant to enter into this Lease) to diligently pursue all governmental approvals and entitlements required or necessary for development and construction of the Premises in accordance with this Lease, provided that Tenant shall use its commercially reasonable good faith efforts to cooperate with Landlord to facilitate said pursuit. (d) Subject to the provisions of this Paragraph 2.2, Landlord shall acquire fee title to the Land in accordance with the provisions of the Purchase Agreement, provided that Tenant shall use its commercially reasonable good faith efforts to cooperate with Landlord to facilitate said acquisition. 2.2.2 Engagement of Architects and Consultants. In order to facilitate construction of the Improvements in accordance with the timing needs of Landlord and Tenant, Tenant has an oral agreement with "Contractor's Architect" (as defined in the Work Letter) to prepare the Construction Drawings (defined in the Work Letter) and Contractor's Architect is in the course of preparing the Construction Drawings. Tenant also has a written agreement with Kimley-Horn & Associates, Inc. ("Kimley-Horn") with respect to engineering due diligence for the acquisition of the Land and construction of the Improvements. Concurrently with the Parties' execution and delivery of the Assignment of the Purchase Agreement pursuant to Paragraph 2.2.1, (i) Tenant shall endeavor to ensure that Contractor's Architect and Kimley-Horn shall each deliver to "Contractor" (defined in the Work Letter) a letter of agreement (each a "Letter Agreement") pursuant to which Contractor's Architect and Kimley-Horn shall assume (and agree to perform) all of the accrued and prospective obligations then owed by Contractor's Architect and Kimley-Horn to Tenant under their respective agreements, (ii) Landlord shall cause Contractor to engage Contractor's Architect and Kimley-Horn to continue to perform their obligations pursuant to their respective agreements, and (iii) Tenant shall assign all of its rights with respect to, and Landlord shall assume (or cause Contractor to assume), in a writing satisfactory to Tenant and Landlord, all of Tenant's accrued obligations to Kimley-Horn and Contractor's Architect with respect to preparation of the Construction Drawings and performance of engineering and due diligence for acquisition of the Land. 2.2.3 Pursuit of Entitlements; Development Schedule. Landlord and Tenant have previously commenced pursuit of, and, subject to the terms of Paragraph 2.2.5, Landlord shall continue to pursue, all governmental approvals and entitlements required for development, construction and use of the Improvements on a basis consistent with this Lease and the Work Letter (collectively, the "Entitlements"). 2.2.4 Due Diligence and Other Performance under the Purchase Agreement by Landlord. (a) Commencing promptly following execution of this Lease, Landlord shall continue its due diligence investigation with respect to acquisition of the Land and development of the Improvements for occupancy by Tenant pursuant to the provisions of this Lease for completion on or before February 26, 2002, including without limitation, for itself and on behalf of Tenant, conducting a review of the Seller's books and records described in Section 5.1.4 of the Purchase Agreement and review and negotiation of all of the matters described in Paragraph 5.1.1 of the Purchase Agreement (including, without limitation, negotiation of the Approved Property Subdivision Map, the Approved Subdivision Improvement Agreement, and the Improvement Agreement (each of which are defined in the Purchase Agreement). 4 (b) Landlord shall promptly keep Tenant informed of all material events, notices, communications and due diligence review results and progress during the Due Diligence Period and prior to the Closing under the Purchase Agreement and shall make arrangements for representatives of Tenant to have the opportunity to attend and participate in all material meetings involving Contractor's Architect, Kimley-Horn, the Seller, the City and other relevant parties prior to the Closing. In turn, Tenant shall make commercially reasonable efforts to promptly cooperate with all of Landlord's requests for coordination with Contractor's Architect, the Seller, the City and Kimley-Horn to permit Landlord's pursuit of the due diligence investigation and the Entitlements (on behalf of Tenant) and the performance under the Purchase Agreement at all times through the Closing. (c) On or before February 26, 2002, Landlord and Tenant shall meet to review the results of Landlord's due diligence review as contemplated by this Section 2.2.4. Subject to Paragraph 2.2.5, provided Tenant has previously assigned the Purchase Agreement to Landlord and has delivered to Landlord the Pre-Closing LC, Landlord shall to deliver to Seller and Escrow Holder (as appropriate) on or before 5:00 p.m., San Diego time, February 26, 2002 the Approval Notice (defined in Paragraph 5.1.8 of the Purchase Agreement) required to maintain the Purchase Agreement in full force and effect as of the expiration of the Due Diligence Period. Subject to the provisions of Paragraph 2.2.5, Landlord shall (i) timely deliver to Escrow Holder all cash deposits (other than the Initial Deposit and the Additional Deposit previously delivered by Tenant to Seller), including, without limitation, the Extension Deposits (defined in the Purchase Agreement) required or permitted to be made by Landlord as the purchaser under the Purchase Agreement in order to have additional time to obtain the Approvals and/or maintain the Purchase Agreement in full force and effect, (ii) deliver to Escrow Holder and Seller, the Notice to Proceed and the Final Deposit (each as defined in Paragraph 3.6 of the Purchase Agreement), (iii) timely perform each of the purchaser's obligations under Paragraphs 5.1, 13.1 and 13.2 of the Purchase Agreement and (iv) otherwise take all commercially reasonable steps as shall otherwise be necessary to maintain the Purchase Agreement in full force and effect. (d) Concurrently with Tenant's assignment of the Purchase Agreement and delivery of the Pre-Closing LC to Landlord and Landlord's delivery to Escrow Holder of the Approval Notice, Landlord shall deliver to Tenant (by wire transfer) in immediately available funds the amount of Seven Hundred Two Thousand One Hundred Twenty-Nine Dollars ($702,129.00) (the "Reimbursed Costs") representing the Initial Deposit and the Additional Deposit plus a portion (described on Exhibit "C" attached hereto) of Tenant's out-of-pocket expenses (actually paid by Tenant) (including, without limitation, architectural, engineering, legal and entitlements expenses) in connection with the transaction contemplated hereunder and due diligence costs of Tenant. 2.2.5 Termination of Purchase Agreement and this Lease. 2.2.5.1 Grounds. Landlord shall have the right to terminate this Lease and the Purchase Agreement (subject to the circumstances set forth in Paragraph 2.2.5.4) at any time (subject to the provisions of this Section 2.2.5) prior to closing ("Closing") its purchase of the Land under the Purchase Agreement (or if specified below, prior to an earlier date specified below) for only one or more of the following reasons: (a) Site Specific Due Diligence Problems. Landlord reasonably determines prior to the expiration of the Due Diligence Period that acquisition of the Land is not commercially feasible due solely to one or more specific site-specific issues relating to (i) the condition or physical characteristics of the Land, (ii) the nature, timing, conditions, exactions or status of the Entitlements (or any adverse zoning or land use condition), or (iii) the condition of title to the Land. Notwithstanding any provision of this Lease to the contrary, if Tenant reasonably determines that any fact discovered concerning the physical condition of the Land, title to the Land or the nature, timing or conditions of the Entitlements (other than purely economic conditions) is materially inconsistent with its good faith objectives for (or materially reduces the benefits of its prospective) use and occupancy of the Premises, Tenant may, by delivery of written notice to Landlord prior to expiration of the Due Diligence Period, require Landlord to promptly terminate the Purchase Agreement. 5 (b) Sale of Tenant. There shall occur any sale of all or substantially all of the assets of Tenant, any sale of all or substantially all of the outstanding stock of Tenant, or any merger or reorganization of Tenant occurring prior to the Closing Date (defined in the Purchase Agreement) which results in a reduction in the net worth of Tenant (or any corporate successor to Tenant) (immediately following such sale, merger or reorganization), as generally determined in accordance with such filings as made by Tenant to the Securities and Exchange Commission, from the net worth of Tenant set forth in Tenant's most recent Form 10-Q filed by Tenant with the Securities and Exchange Commission for the calendar quarter ending October 31, 2001; provided, however, that Landlord's right to terminate this Lease under this Paragraph 2.2.5.1(b) shall automatically terminate (and shall be of no further force or effect) concurrently with Landlord's delivery of the Notice to Proceed (defined in the Purchase Agreement). (c) Material Financial Decline. There shall occur any decline in Tenant's Stockholders Equity ("Stockholders Equity") (as calculated in Tenant's audited financial statements dated May, 2001 (the "May Financials") reported in any Form 10-K or Form 10-Q filing by Tenant prior to the Closing Date (defined in the Purchase Agreement) in an amount greater than forty percent (40%) of the Stockholders Equity of Tenant reported in the May Financials; provided, however, that Landlord's rights to terminate this Lease under this Paragraph 2.2.5.1 (c) shall automatically terminate (and shall be of no further force or effect) concurrently with Landlord's delivery of the Notice to Proceed. (d) Bankruptcy. There shall occur any voluntary filing in bankruptcy by Tenant occurring prior to the Closing Date (defined in the Purchase Agreement), or any involuntary filing in bankruptcy against Tenant occurring prior to the Closing Date which is not dismissed within sixty (60) days thereafter. (e) Tenant Breach. Prior to the Closing Date, there shall occur any Tenant Breach of this Lease under Paragraph 13.1; provided, that nothing contained in this Paragraph 2.2, shall limit Landlord's remedies under Paragraph 13.2 for a Tenant Breach occurring on or after the Closing. (f) Nonissuance of the Approvals. The nonissuance or disapproval of the Approvals (defined in the Purchase Agreement) under circumstances where no further extensions of the Closing are permitted under the Purchase Agreement under any circumstances without payment of an extension fee. (g) Seller Default. Landlord terminates the Purchase Agreement on account of the existence of a material Seller default under the Purchase Agreement (which entitles Landlord to so terminate the Purchase Agreement pursuant to the provisions thereof). 2.2.5.2 Substitute Purchase Agreement. In the event Landlord shall terminate the Purchase Agreement (or Tenant shall require Landlord to terminate the same) pursuant to Paragraph 2.2.5.1(a): (a) the parties shall cooperatively work together in good faith until April 15, 2002 to attempt to identify a new site to be substituted for the Land ("Alternate Site"); (b) in the event that the Parties do identify (prior to April 15, 2002, or any later date on which both Parties, in the exercise of their sole and absolute discretion, shall agree) an Alternate Site which is acceptable in good faith to both Parties (and with respect to which all terms relating to the acquisition and development thereof are acceptable to both Parties), the Parties shall promptly execute and deliver an amendment to this Lease ("Alternate Site Amendment") addressing the issues raised by the acquisition of such Alternate Site, including, without limitation, the schedule of development and construction therefor; and (c) in the event that the Parties do not execute and deliver an Alternate Site Amendment prior to April 15, 2002, at any time following April 15, 2002, either Party hereto may (in the exercise of such Party's sole and absolute discretion) terminate this Lease, effective upon delivery of written notice to the other party hereto. 6 2.2.5.3 Termination of this Lease. (a) In the event that this Lease shall be terminated by Landlord pursuant to Paragraph 2.2.5.1(b), (c), (d) or (e): (i) Tenant shall, in satisfaction of all liabilities and obligations owed to Landlord hereunder, reimburse Landlord, within the earlier of the date of reassignment of the Purchase Agreement by Landlord to Tenant under Paragraph 2.2.5.4 below, or thirty (30) days of receipt by Tenant of Landlord's reasonably detailed invoice therefor (which shall enclose reasonable supporting documentation), for all out-of-pocket expenses incurred in any manner prior to the date of such termination by Landlord in connection with the negotiation and performance of this Lease, and pursuit of purchase of the Land including, without limitation, all costs incurred in pursuit of any Entitlements and all Improvement Costs (defined in the Work Letter) so paid or incurred, all deposits under the Purchase Agreement not refunded to Landlord, and any extension payments under the Purchase Agreement and including the Reimbursed Costs ("Landlord's Out of Pocket Expenses"), (ii) immediately upon delivery of such reimbursement (in accordance with the preceding clause (i)) by Tenant to Landlord, Landlord shall return the Pre-Closing LC to Tenant, and (iii) upon performance by the Parties under the preceding clauses (i) and (ii), subject to the provisions of Paragraph 2.2.5.4, all other obligations of each Party hereto to the other Party hereunder shall automatically terminate and be of no further force or effect. In the event that Tenant shall not fully reimburse Landlord for Landlord's Out of Pocket Expenses within the applicable period described in clause (i) above, Landlord may draw under the Pre-Closing LC an amount equal to its unreimbursed Landlord Out of Pocket Expenses. To the extent the Pre-Closing LC does not fully reimburse Landlord in full for Landlord's Out of Pocket Expenses, Landlord may pursue against Tenant payment by Tenant for any such deficiency and Tenant shall remain liable for its obligations to Landlord for any remaining unpaid Landlord's Out of Pocket Expenses. (b) In the event that this Lease shall be terminated by either Landlord or Tenant under Paragraph 2.2.5.1(a), Paragraph 2.2.5.1(f) or Paragraph 2.2.5.2, (i) Tenant shall reimburse Landlord, within thirty (30) days of receipt by Tenant of a reasonably detailed invoice from Landlord therefor, for fifty percent (50%) of all fees and expenses incurred or reimbursed by Landlord in favor of Contractor's Architect and Kimley-Horn in connection with the site due diligence and preparation of the Construction Drawings, (ii) within the time period specified in clause (i), Tenant shall reimburse Landlord for $100,000.00 of the Reimbursed Costs previously delivered by Landlord to Tenant, (iii) each Party shall bear all of their other costs and expenses (without further reimbursement by the other Party hereto), (iv) the Parties shall perform their respective obligations under Paragraph 2.2.5.4, and, provided Landlord receives all of the amounts owed to Landlord described in clauses (i), (ii) and (iii) above, Landlord shall return the Pre-Closing LC to Tenant and (v) each and all of the other rights and obligations of the Parties hereunder (other than under clauses (i), (ii) (iii) and (iv) above) shall automatically terminate and shall be of no further force or effect. In the event that this Lease is terminated by Landlord under this Paragraph 2.2.5.3(b), and Tenant does not fully reimburse Landlord as required under this Paragraph 2.2.5.3(b) within the time period specified above, Landlord may draw under the Pre-Closing LC an amount equal to the amounts still owed to Landlord by Tenant pursuant to this Paragraph 2.2.5.3(b). (c) In the event that this Lease is terminated by Landlord under Paragraph 2.2.5.1(g), (i) Tenant shall reimburse Landlord for $100,000.00 of the Reimbursed Costs previously delivered by Landlord to Tenant, (ii) Landlord shall, immediately following receipt of such reimbursement in full from Tenant, return the Pre-Closing LC to Tenant, (iii) each Party shall bear all of their remaining costs and expenses (without further reimbursement by the other Party hereto) and (iv) each and all of the other rights and obligations of the Parties hereunder (other than under clauses (i), (ii) and (iii) above) shall automatically terminate and shall be of no further force or effect. (d) Notwithstanding any provision of this Paragraph 2.2 to the contrary, in the event that the Land is not acquired by Landlord under the Purchase Agreement due to either (i) breach of Landlord's obligations under the Purchase Agreement (provided that any termination of this Lease by Landlord pursuant to Paragraphs 2.2.5.1(a), (b), (c), (d), (e), (f) and (g) shall in no case constitute such a breach) or (ii) any material breach of Landlord's obligations under Paragraph 2.2 of this Lease, in addition and without prejudice to any other rights or remedies Tenant may otherwise have with respect thereto hereunder, at law or in equity, Tenant shall have no obligation to reimburse Landlord for any amount relating to this Lease, the Purchase Agreement, the Property or any transaction relating thereto, the preparation of plans for the Premises or any other matter in connection therewith. 7 2.2.5.4 Landlord Obligations with Respect to the Purchase Agreement. In the event that this Lease shall be terminated by Landlord under Paragraphs 2.2.5.1(a), (b), (c), (d) or (e), upon the request of Tenant (delivered by Tenant to Landlord not later than the date ("Assignment Notice Date") which is the earlier of (i) ten (10) days following delivery to Tenant by Landlord of written notice of termination of this Lease; and (ii) one business day prior to the last date for delivery of the Notice to Proceed required under the Purchase Agreement (and in the case of Paragraph 2.2.5.1(a), Tenant must notify Landlord of such assignment)), Landlord shall promptly (not later than the date ("Reassignment Deadline") five (5) business days thereafter or in any event the last date for delivering of the Notice to Proceed under the Purchase Agreement) assign the Purchase Agreement and in connection therewith, take such action, at no cost or additional liability to Landlord, as may be reasonably requested of it by Tenant, including, without limitation, the execution and delivery of assignment documents, in order to provide for the assignment to Tenant of all of Landlord's rights as the purchaser under the Purchase Agreement (provided, however, that as a condition of such assignment, Tenant shall be required to concurrently pay to Landlord in cash by wire transfer the amount of any cash purchase price deposits of Landlord then on deposit in Escrow in connection with the Purchase Agreement together with any other amounts owed by Tenant to Landlord as provided in this Paragraph 2.2) (including, in the event of termination under Paragraph 2.2.5.1(b), (c), (d) or (e), Landlord's Out of Pocket Expenses); provided, further, however, that in the case of an intentional Tenant Breach, including Tenant's failure to maintain the Pre-Closing LC as required by this Lease (and termination of this Lease on account of such intentional Tenant Breach under Paragraph 2.2.5.1(e)), Tenant's rights under this Paragraph 2.2.5.4 shall not be applicable and Landlord shall be entitled to reimbursement of Landlord's Out of Pocket Expenses pursuant to Paragraph 2.2.5.3(a). In addition, if Tenant fails to timely (i.e., on or before the Reassignment Deadline) deliver the amounts required by the preceding sentence, then Landlord shall not be required to so assign the Purchase Agreement to Tenant, and Landlord may exercise whatever rights or remedies Landlord deems necessary or appropriate in connection therewith (subject, however, to the limitations set forth in Paragraphs 2.2.5.3(a) and (b), as applicable), including, without limitation, closing under (or termination of) the Purchase Agreement and pursuing reimbursement (including, without limitation, through draws by Landlord on the Pre-Closing LC as set forth in Paragraph 2.2.5.3) of any amounts then payable to Landlord by Tenant pursuant to this Paragraph 2.2 2.2.6 Survival. Except as otherwise provided for in this Paragraph 2.2, the terms of this Paragraph 2.2 shall survive the expiration or earlier termination of this Lease. 2.3 Intentionally Deleted. 2.4 Condition. In accordance with (and subject to) the provisions of the Work Letter, Landlord shall deliver the Premises (other than any Fixture Work, as defined in the Work Letter) to Tenant (and Tenant shall accept the Premises from Landlord) broom clean and free of debris (other than arising from any Fixture Work) immediately upon the Commencement Date. 2.5 Acknowledgments. Tenant acknowledges that neither Landlord nor Landlord's agents or employees has made any oral or written representations or warranties, express or implied or arising by operation of law, with respect to the condition of the Premises and the suitability or fitness for the Agreed Use, other than as expressly set forth in this Lease and the Work Letter. Tenant's acceptance of the Premises on the Commencement Date shall be on an "AS-IS," "WHERE-IS" basis, without representation or warranty from Landlord with respect thereto, other than as expressly set forth in this Lease and the Work Letter. 8 3. Lease Term. Subject to the provisions of Section 7.2.2 of the Work Letter, the Original Term of this Lease (a) shall commence on the Commencement Date (defined and calculated pursuant to Section 6.2 of the Work Letter), and (b) shall end on the Expiration Date, unless sooner terminated as provided herein or extended pursuant to Paragraph 47 below. Within thirty (30) days after the Commencement Date, the Parties shall execute and deliver to each other a Commencement Date Memorandum in the form attached hereto as Exhibit "D" acknowledging (i) the Commencement Date and Expiration Date, and (ii) subject to the provisions of Section 2.3 of the Work Letter, the First Period Monthly Base Rent payable under this Lease. The terms and provisions of this Lease are effective as of the date of execution of this Lease, except Tenant's obligation to pay Base Rent (as defined in Paragraph 4.1 below), to the extent set forth in Paragraph 4.3 hereof, which shall not commence until the Rent Commencement Date. 4. Rent. 4.1 Rent Defined. All monetary obligations of Tenant to Landlord under the terms of this Lease, including, without limitation, Base Rent and Additional Rent (as defined below), are deemed to be "Rent." All monetary obligations of Tenant payable to Landlord under the terms of this Lease which do not constitute Base Rent are deemed to be "Additional Rent." 4.2 Payment. Tenant shall pay Rent to Landlord in lawful money of the United States, without notice, offset, abatement or deduction (except as may be expressly and specifically permitted in this Lease), promptly on or before the day on which it is due. Rent for any period during the Lease Term hereof which is for less than one (1) full calendar month shall be prorated based upon the actual number of days of said month. All payments of Rent shall be paid to ORIX Real Estate Equities, Inc., 100 North Riverside Plaza, Suite 1400, Chicago, Illinois 60606 (or such other entity designated as Landlord's management agent, if any, and if Landlord so appoints such a management agent, the ("Agent"), or pursuant to such other directions as Landlord shall designate in this Lease or otherwise in writing, from time to time, not less than thirty (30) days in advance of such applicable payment of Rent. No payment by Tenant, or receipt or acceptance by Agent or Landlord, of a lesser amount than the correct Rent shall be deemed to be other than a payment on account, nor shall any endorsement or statement on any check or letter accompanying any payment be deemed an accord or satisfaction, and Agent or Landlord may accept such payment without prejudice to its right to recover the balance due or to pursue any other remedy available to Landlord. 4.3 Early Occupancy Period. Notwithstanding any provision of this Lease to the contrary, Tenant shall have no obligation to pay Base Rent for the period consisting of Lease Months one (1) two (2) and three (3) of the Original Term ("Early Occupancy Period"). 5. The Letter of Credit. 5.1 The Letter of Credit. Each letter of credit (a "Letter of Credit" or "LC") described in this Lease or the Work Letter: (a) shall be an irrevocable and unconditional Letter of Credit substantially in the form of Exhibit "E" attached hereto; and (b) shall be issued by The Chase Manhattan Bank or such other commercial bank, trust company or national bank association having offices for banking and drawing purposes in the City of San Diego or in the City of Los Angeles and which (or the parent company of which) has a rating of at least "B" under the Moody's rating standards ("Issuing Bank"); and (c) in the case of the Primary LC, shall be in the amount of Two Million Six Hundred Thousand and No/100 Dollars ($2,600,000.00) (the "LC Amount"); and 9 (d) shall name Landlord as the beneficiary thereunder; and (e) shall be for an initial term of not less than one (1) year; and (f) shall, in the case of the Primary LC, subject to the provisions of Paragraph 5.2, be maintained in full force and effect for ten (10) years from the Rent Commencement Date; and (g) shall permit multiple drawings; and (h) shall be fully transferable by Landlord (provided that Landlord shall bear at its sole cost and expense all commercially reasonable charges of the Issuing Bank in connection with any such transfer and Tenant shall pay any excess charges); and (i) shall state that drafts drawn under and in compliance with the terms of the Letter of Credit will by duly honored upon presentation of the original site draft to the Issuing Bank at an office located in San Diego, California or Los Angeles, California; and (j) shall be subject in all respects to the Uniform Customs and Practice for Documentary Credits (1993 revision), International Chamber of Commerce Publication No. 500; and (k) shall conform to the requirements of this Paragraph 5. 5.2 Reductions in Amount. 5.2.1 Reduction Preconditions. As a precondition to any reduction in the LC Amount, Tenant shall meet each and every of the following "Reduction Preconditions" prior to such reduction in the LC Amount described in this Paragraph 5.2: (i) this Lease is in full force and effect, (ii) Tenant is not then in Breach under this Lease, and (iii) Tenant has not assigned its interest in this Lease or subleased any portion of the Premises in violation of the terms of this Lease and such violation remains uncured; provided, however; that in the event any Reduction Precondition is not satisfied as of a date the reduction in the LC Amount would otherwise apply, such reduction in the LC Amount shall automatically apply on the first date such Reduction Preconditions shall be satisfied. 5.2.2 Scheduled Reductions. Subject to the provisions of this Paragraph 5.2 and provided the LC Amount is not reduced by the 16.67% Amount (as defined in Paragraph 5.2.3 below) or the 20% Amount (as defined in Paragraph 5.2.4 below), on the ninth (9th) anniversary of the Rent Commencement Date the Letter of Credit Amount of the Primary LC shall be reduced to fifty percent (50%) of the original LC Amount and on the tenth (10th) anniversary of the Rent Commencement Date, the Letter of Credit Amount of the Primary LC shall be reduced by an additional fifty percent (50%) of the original LC Amount (such that the Primary LC shall be eliminated on such date). 5.2.3 $40,000,000 Net Worth Reductions. Notwithstanding any provision of this Lease to the contrary, subject to Paragraphs 5.2.4 and 5.2.5, (a) if the Tangible Net Worth (defined below) of Tenant shall be Forty Million Dollars ($40,000,000.00) or more as of the fifth (5th) anniversary of the Rent Commencement Date, on such date the LC Amount shall be reduced by an amount equal to sixteen and two-thirds percent (16.67%) of the original LC Amount (the "16.67% Amount"), and (b) provided that the Tangible Net Worth of Tenant shall be equal to or greater than Forty Million Dollars ($40,000,000) (the "$40M Test") on the sixth (6th), seventh (7th), eighth (8th), ninth (9th) and/or tenth (10th) anniversary of the Rent Commencement Date, then as of each such anniversary that the $40M Test is satisfied, the LC Amount shall be reduced by an amount equal to the 16.67% Amount, such that if the $40M Test shall be 10 satisfied on each of the 5th, 6th, 7th, 8th, 9th and 10th anniversaries of the Rent Commencement Date, the LC Amount shall be reduced to zero (in equal annual reductions) on the 10th anniversary of the Rent Commencement Date. "Tangible Net Worth" of Tenant as of any particular date shall be equal to the amount designated as stockholder's equity minus the amount of good will reported in Tenant's then most recent Form 10-K or Form 10-Q filed with the Securities and Exchange Commission (or if then more recent, reported in Tenant's most recent audited financial statements). Notwithstanding anything to the contrary contained herein, if any reduction in the LC Amount specified in this Paragraph 5.2.3 is given effect, then the reduction in the original LC Amount specified in Paragraph 5.2.2 for the ninth anniversary of the Rent Commencement Date shall be effective only if and to the extent the LC Amount then exceeds fifty percent (50%) of the original LC Amount. 5.2.4 $75,000,000 Net Worth Reductions. Notwithstanding any provision of this Lease to the contrary, subject to the provisions of Paragraph 5.2.5, (a) if the Tangible Net Worth of Tenant shall be Seventy-Five Million Dollars ($75,000,000.00) or more as of the fifth (5th) anniversary of the Rent Commencement Date, on such date the LC Amount shall be reduced by an amount equal to twenty percent (20%) of the original LC Amount (the "20% Amount") and (b) provided that the Tangible Net Worth of Tenant shall be equal to or greater than Seventy-Five Million Dollars ($75,000,000.00) (the "$75M Test") on the sixth (6th), seventh (7th), eighth (8th) and/or ninth (9th) anniversary of the Rent Commencement Date, then as of each such anniversary that the $75M Test is satisfied, the LC Amount shall be reduced by an amount equal to the 20% Amount, such that if the $75M Test is satisfied on each of the 5th anniversary through the 9th anniversaries of the Rent Commencement Date, the LC Amount shall be reduced to zero as of the ninth anniversary of the Rent Commencement Date. Notwithstanding anything to the contrary contained herein, (i) if any reduction in the original LC Amount specified in this Paragraph 5.2.4 is given effect as of a particular applicable anniversary of the Rent Commencement Date, then the reductions specified in Paragraph 5.2.3 shall not also apply on such applicable anniversary and (ii) if any reduction in the original LC Amount specified in this Section 5.2.4 is given effect, then the reduction in the original LC Amount specified in Paragraph 5.2.2 for the ninth anniversary of the Rent Commencement Date shall be effective only if and to the extent the LC Amount then exceeds fifty percent (50%) of the original LC Amount. 5.2.5 Achievement of Investment Grade Rating. If, at any time following delivery of the Primary LC, Tenant receives an investment grade rate of "BBB-" or better from Standard & Poor's Corporation (or if Standard & Poor's Corporation no longer issues such ratings, any comparable rating from another comparable rating agency) for four (4) consecutive quarters (the "Required Investment Rating"), (a) Tenant shall no longer, subject to the provisions of this Paragraph 5.2.5, be required to provide to (or maintain with) Landlord any letter of credit or comparable security under this Lease and (b) within thirty (30) days of delivery by Tenant to Landlord of written notice that Tenant has achieved the Required Investment Rating, Landlord shall return to Tenant the Primary LC. Notwithstanding the foregoing, in the event Tenant thereafter (following return of the Primary LC) fails to so maintain such Required Investment Rating, Landlord may require Tenant to redeliver to Landlord, within thirty (30) days of delivery to Tenant of Landlord's written request to do so, a Letter of Credit conforming to the requirements for the Primary LC under this Paragraph 5, with the LC Amount thereof being the amount which would otherwise then be applicable pursuant to this Paragraph 5.2 had such Primary LC not been so returned by Landlord; provided, however, that Tenant shall continue to be eligible thereafter to qualify for reduction of the LC Amount under and return of the Primary LC pursuant to this Paragraph 5.2. 5.3 Application of the LC. (a) Subject to the provisions of Paragraphs 1.6, 5.1 and 5.2, each Letter of Credit delivered by Tenant to Landlord pursuant to Paragraph 1.6 shall be held by Landlord as security for the faithful performance by Tenant of each and all of the terms, covenants, and conditions of this Lease to be kept and performed by Tenant. Each Letter of Credit shall not be mortgaged, assigned or encumbered in any manner whatsoever by Tenant without the prior written consent of 11 Landlord, which consent may be withheld in Landlord's sole discretion. If (i) Tenant commits a Breach of the provisions of this Lease including, but not limited to, a Breach of the obligations of Tenant relating to the payment of Rent, (ii) Tenant files a voluntary petition in bankruptcy, (iii) an involuntary petition in bankruptcy is filed against Tenant and the same is not discharged within sixty (60) days thereafter or (iv) Tenant fails to renew the Primary LC at least thirty (30) days before its expiration (and such failure to renew occurs during that portion of the Term that Tenant is required to maintain the Primary LC hereunder), or (v) with respect to the Pre-Closing LC, Tenant fails to reimburse Landlord for any amounts owed to Landlord under Paragraph 2.2 hereof, Landlord may, but shall not be required to, draw upon all or any portion of any such Letter of Credit to the extent necessary (i) to cover the payment of any Rent or any other sum in default under this Lease (ii) to cover the payment of any other amount which Landlord may spend or become obligated to spend as the result of Tenant's default under this Lease, and/or (iii) subject to the provisions of Paragraph 2.2, to compensate Landlord for any loss or damage which Landlord will likely suffer by reason of Tenant's default, including, without limitation, costs of enforcement and, if this Lease has been terminated by Landlord on account of Tenant's Breach, any damages under California Civil Code Section 1951.2 (collectively, "LC Applications"); provided, however, notwithstanding the foregoing provisions of this Paragraph 5.3(a), in the event clause (v) above applies, the LC Application with respect thereto shall be limited to amounts to be reimbursed by Tenant to Landlord under Paragraph 2.2 which remain unpaid. To the extent that Landlord draws upon all or any part of any Letter of Credit delivered by Tenant to Landlord hereunder for other than (and to the extent of) an LC Application (a "Disallowed Application"), and if Landlord does not refund the Disallowed Application to Tenant within 15 days after demand from Tenant (in which case Tenant shall then restore the Primary LC to the amount which would have applied but for the Disallowed Application) Tenant may, without prejudice to its other remedies, deduct the amount of the Letter of Credit determined to have been drawn by Landlord for the Disallowed Application, together with interest thereon from the date of the draw at the Interest Rate, from the Rent next due and owing under the Lease. (b) The use, application, or retention of the Letter of Credit, or any portion thereof, by Landlord shall not prevent Landlord from exercising any other right or remedy provided by this Lease or by law or in equity, it being intended that Landlord shall not first be required to proceed against any Letter of Credit, and the Letter of Credit Amount shall not operate as a limitation on any recovery to which Landlord may otherwise be entitled. Any amount of the Letter of Credit which is drawn upon by Landlord in excess of the LC Applications, shall be refunded to Tenant. If any portion of the Letter of Credit is drawn upon for any LC Application, and this Lease is not terminated as a result of a Tenant Breach, Tenant shall, within ten (10) days after written demand therefor reinstate the Letter of Credit to the amount then required under this Lease. In the event of a sale of Landlord's interest in the Premises, (i) Tenant shall reasonably cooperate (at no expense to Tenant) with any requests for assistance from Landlord or the purchaser in connection with transfer of the Letter of Credit to the new landlord as designated by Landlord, or have the Letter of Credit reissued in the name of the new landlord, and (ii) provided that the new landlord shall have assumed all of Landlord's obligations under this Lease pertaining to the Letter of Credit (if applicable), the selling Landlord shall thereupon be deemed released by Tenant from all liability pertaining to the Letter of Credit. (c) Tenant waives all limitations on the rights of Landlord to draw, retain, or use the proceeds of any Letter of Credit set forth in California Civil Code Section 1950.7(c). 6. Use. 6.1 Use. Tenant shall use and occupy the Premises only for the Agreed Use and for no other purpose without the prior written consent of Landlord. Tenant shall not use, or knowingly permit the use of, the Premises in a manner that (a) constitutes waste or a nuisance, (b) would impair the structural elements of the Premises or any of the basic building systems thereof, (c) subject to the provisions of Sections 6.2 and 6.3 would constitute a violation of Applicable Requirements (defined below) or any covenant, condition or restriction affecting the Premises shown in that certain Chicago Title Insurance Company preliminary title report No. 23066030-U50, dated February 13, 2002, or any matters arising under Paragraph 41, or (d) would exceed the load bearing capacity of the floor of the Premises. Landlord shall not unreasonably withhold, condition or delay its consent to any written request for a modification of the Agreed Use for the Premises which is legally permitted under applicable laws and is compatible with comparable industrial light manufacturing and/or warehouse and distribution facilities located in the Otay Mesa area of San Diego, California (collectively, the "Comparable Buildings"). If Landlord elects to withhold consent to any Tenant proposal for modification of the Agreed Use, Landlord shall concurrently with its notice to Tenant that Landlord elects to withhold its consent include a reasonable explanation of Landlord's objections to the change in use. 12 6.2 Hazardous Substances. 6.2.1 Definitions. As used herein, the term "Hazardous Substance" includes any hazardous, explosive, radioactive, regulated, biological, or toxic substance, material or waste which is regulated by any local governmental authority, the state in which the Premises is located or the United States, including, without limitation, any material or substance which is (a) defined or listed as a "hazardous waste," "extremely hazardous waste," "restricted hazardous waste," "hazardous substance," "hazardous material," "pollutant" or "contaminant" under any law, (b) petroleum or a petroleum derivative, (c) a flammable explosive, (d) a radioactive material, (e) a polychlorinated biphenyl, (f) asbestos or asbestos containing material, (g) urea, formaldehyde, foam insulation, (h) radon gas or (i) a Proposition 65 chemical. "Environmental Laws" means any statute, law, rule, regulation ordinance or order that directly regulates the storage, use, transportation, release, processing, disposal, presence or remediation of Hazardous Substances. 6.2.2 Use. --- Tenant and the Tenant Parties shall (a) not use, generate, handle, store or transport to or from the Premises any Hazardous Substance other than Hazardous Substances consistent with (or customary for) the use, generation, handling, storage or transport of tenants in comparable warehouse, light manufacturing and/or distribution buildings in the Otay Mesa, San Diego market, without the prior written approval of Landlord, which approval shall not be unreasonably withheld, conditioned or delayed, (b) use, store, handle, generate and transport all Hazardous Substances brought onto or generated at the Premises by Tenant or by a Tenant Party in accordance with all applicable Environmental Laws, (c) obtain and maintain in full force and effect all governmental permits and approvals required under applicable Environmental Laws as the result of the use, storage, handling, generation or transport of any Hazardous Substance by Tenant or by a Tenant Party on or about the Premises, (d) promptly provide Landlord with copies of all such approvals and permits and copies of all material correspondence received from or given to any governmental agency or official concerning the release of (or any violation of Environmental Laws with respect to) Hazardous Substances in, on or about the Premises, and (e) promptly provide Landlord written notice of any release into the environment of any Hazardous Substances brought onto or generated at the Premises by Tenant or a Tenant Party in, on or about the Premises (if any of Tenant's onsite management or executive management has actual knowledge that such release of Hazardous Substances has occurred). 6.2.3 Remediation Obligations. (a) Tenant hereby agrees that reasonably promptly following receipt of written notice from any applicable governmental agency of the need to do so, Tenant will remediate (and investigate), at Tenant's sole cost and expense, on a basis consistent with applicable Environmental Laws, any release into the environment in, on, or under the Premises of any Hazardous Substance brought onto or generated at the Premises by Tenant or any Tenant Party which is required to be remediated under applicable Environmental Laws, to the extent such release of Hazardous Substance results or resulted from the acts or omissions of Tenant or any Tenant Party. In those instances where Tenant has a duty to remediate Hazardous Substances pursuant to the immediately preceding sentence, Tenant shall, subject to obtaining approval of a remediation plan therefor in accordance with Paragraph 6.2.3(b), commence such remediation with reasonable promptness, and thereafter shall pursue at Tenant's sole cost and expense (to the extent provided in this Section 6.2.3(b)), such remediation to completion with reasonable promptness. Tenant hereby agrees that any such remediation required to be performed under this Section 6.2.3 shall be conducted strictly in compliance with applicable Environmental Laws (the "Cleanup Standard"). 13 (b) In any case where Tenant is required by Landlord (pursuant to the provisions of this Lease) or by any other party to remediate (or bear the cost of remediating) any Hazardous Substance in, on, under or about the Premises, Tenant shall be permitted: (i) subject to reasonable participation by Landlord, to supervise the investigation of the extent of the release into the environment of the Hazardous Substance in question, (ii) subject to the provisions of this Paragraph 6.2.3, to structure and negotiate the terms of any remediation plan with respect to such release of Hazardous Substances to be submitted to and approved by the governmental authorities having jurisdiction under applicable Environmental Laws, provided, however, except in the case of an Emergency (defined in Paragraph 7.4(a) below) (in which case Landlord's prior approval shall not be required), each such remediation plan shall be subject to the prior written approval of Landlord, which approval shall not be unreasonably withheld, conditioned or delayed, and (iii) subject to reasonable participation by Landlord, to supervise the actual remediation of such Hazardous Substance contamination. In connection with the foregoing, Tenant shall be provided with reasonable access to all portions of the Premises relevant to the foregoing activities, provided that Tenant agrees to repair any damage to the Premises caused by such activities (provided that any such access after expiration or termination of this Lease shall be subject to an access agreement reasonably required by Landlord). Landlord and its agents and employees shall have the right following reasonable prior notice to Tenant to either or both (a) enter the Premises; (b) inspect and monitor Tenant's compliance with all obligations of Tenant under Paragraph 6.2 relating in any way to the generation, transport, storage, use, treatment or disposal of Hazardous Substances on, at, in or from the Premises or any portion thereof, and (c) conduct tests with respect to the presence (or remediation) of Hazardous Substances; provided, however, that Landlord shall use commercially reasonable efforts to minimize any interference with Tenant's business operations resulting from such activities of Landlord and shall promptly restore any damage to the Premises caused by its testing. In the event any such remediation plan described in this Paragraph 6.2.3 (b) contemplates that such remediation will extend beyond the Term, Landlord may elect to complete, or cause to be completed, at Tenant's sole cost and expense, the portion of such remediation work to be performed after the expiration of the Term. In the event Tenant fails to commence to perform and thereafter diligently pursue to completion any remediation required to be performed by Tenant under this Paragraph 6.2, and such failure continues (following delivery of written notice of such failure to Tenant) for the applicable period described in Paragraph 13.1 (or in the event of an Emergency, three (3) business days), Landlord shall, in addition to Landlord's rights and remedies hereunder, have the right, but not the obligation, to perform and/or complete such remediation work, at Tenant's sole cost and expense, at Landlord's sole election upon written notice to Tenant. (c) As to any Hazardous Substance (i) released into the environment in, on, under or about the Premises prior to the Commencement Date for any reason (other than any Hazardous Substance so released which is required to be remediated by Tenant pursuant to the express terms of Paragraph 6.2) or (ii) released into the environment in, on, under or about the Premises as the result of the negligence or misconduct of Landlord or any of its agents, employees, contractors or Affiliates and which is required to be remediated under applicable Environmental Laws, Landlord shall (without any cost or expenses to Tenant), subject to obtaining approval of the remediation plan described below, promptly commence (or cause to be commenced) such remediation with reasonable promptness following the receipt of written notice from Tenant or any applicable governmental agency of the requirement under applicable Environmental Laws for such remediation, and thereafter shall pursue such remediation of such released Hazardous Substances to completion pursuant to a remediation plan consistent with the Cleanup Standard, approved by all appropriate regulatory agencies (and if such remediation would have an adverse impact on Tenant's use and enjoyment of the Premises and would occur or continue at any time following the Commencement Date, reasonably approved in advance by Tenant which approval shall not be unreasonably withheld, conditioned or delayed by Tenant) and in compliance with all applicable Environmental Laws. 6.2.4 Landlord's Obligations. In the event any release into the environment of Hazardous Substances occurs in, on, under or about the Premises prior to the Commencement Date for any reason or occurs at any time in, on, under or about the Premises as the result of the negligence or willful misconduct of Landlord or any of its agents, employees, contractors or Affiliates, subject to Tenant's obligations under Paragraph 6.2, Tenant shall have no responsibility or liability whatsoever to Landlord with respect to the existence or remediation of such contamination, and Landlord shall take all steps reasonably necessary to assure that such Hazardous Substances (and Landlord's investigation and remediation thereof) shall not materially interfere with Tenant's use and enjoyment of the Premises or the operation of Tenant's business thereon. 14 6.2.5 Survival. Notwithstanding any provision to the contrary contained in this Lease, the provisions of this Paragraph 6.2 shall survive the expiration or earlier termination of this Lease. 6.3 Compliance with Law Requirements. 6.3.1 Tenant's Compliance with Laws. Subject to the provisions of Paragraph 6.2 and this Paragraph 6.3, Tenant shall, at its sole cost and expense, comply with all local, state, and federal laws, rules, codes, regulations, requirements and orders now or hereafter in force (collectively, "Applicable Requirements") pertaining to the Premises and Tenant's use of the Premises; provided, however, that notwithstanding any provision of this Lease to the contrary, (a) no portion of this Paragraph 6.3 (including, without limitation, this Paragraph 6.3.1) shall impose any obligations or liability on either Landlord or Tenant with respect to compliance with Environmental Laws applicable in any way to the Premises (or to any Hazardous Substances in, on, under or about the Premises), (b) the provisions of this Paragraph 6.3.1 shall in no way limit or modify the obligations of Tenant to perform its obligations expressly provided in Paragraph 6.2 with respect to compliance with Environmental Laws, (c) all references in this Lease to "Applicable Requirements" shall include, with respect to Tenant, Tenant's obligations to comply with Environmental Laws under the express provisions of Paragraph 6.2 and (d) the liabilities and obligations of each of Tenant and Landlord under this Lease with respect to compliance with Environmental Laws and otherwise concerning the presence of Hazardous Substances in, at or on the Premises are provided in Paragraph 6.2 hereof. If any license or permit is required for the conduct of Tenant's business in the Premises, Tenant, at its expense, shall procure such license prior to the date required under Applicable Requirements, and shall maintain such license or permit in good standing throughout the Term (to the extent so required). Tenant shall give prompt notice to Landlord of any written notice it receives from any governmental agency or official of the alleged violation of any Applicable Requirements with respect to the Premises and the use or occupation thereof. 6.3.1.1 Improvements Compliance. Subject to the provisions of Paragraphs 6.2.2 and 6.2.3 and the Work Letter, Landlord shall cause, at Landlord's sole cost and expense, the Improvements to be in compliance with all Applicable Requirements in effect on the Commencement Date of this Lease to the extent provided in the Work Letter (the "Initial Landlord Compliance Obligation"). If and to the extent that at any time during the Term, either Landlord or Tenant discovers a violation of such Initial Landlord Compliance Obligation (which violation existed as of the Commencement Date of this Lease), Landlord shall, at its sole cost and expense, promptly cure such violation; provided, however, that (i) the provisions of this Paragraph 6.3 shall in no way limit or modify the obligations of Landlord to perform its obligations expressly provided in Paragraph 6.2 with respect to compliance with Environmental Laws and (ii) all references in this Lease to "Applicable Requirements" shall include, with respect to Landlord, Landlord's obligations to comply with Environmental Laws under the express provisions of Paragraph 6.2. 6.3.1.2 Changes In Applicable Requirements Following the Commencement Date. (a) Subject to the provisions of this Paragraph 6.3, in the event that following the Commencement Date of this Lease, new Applicable Requirements are adopted which require modifications, alterations, changes, additions, deletions or improvements to the Improvements (collectively, "Law Changes") Tenant shall cause such Law Changes to be made promptly and diligently; provided, however, that if and to the extent such Law Changes relate directly to the Landlord Replacement Items (defined in Paragraph 7.2), Landlord shall be responsible to make and effect directly such Law Changes promptly and diligently. 15 (b) If and to the extent any such Law Change to the Improvements constitutes a capital item under generally accepted accounting principles, consistently applied ("GAAP") as reasonably determined by Landlord and Tenant (a "Capital Item"), the total out-of-pocket cost and expense (incurred by Tenant and Landlord in effecting and completing such Capital Item) with respect to such Law Change pursuant to this Paragraph 6.3.1.2 ("Law Change Capital Cost") shall be allocated between Landlord and Tenant on the basis of the reasonable useful life (as determined under GAAP) of the Capital Item in question (expressed in terms of full calendar months) and the then (as of the date of completion of the Capital Item) remainder of the Original Term (or if applicable, Option Term) (expressed in terms of full calendar months), with the Tenant to bear (and pay to Landlord), for each month of the Original Term remaining following such completion of the Capital Item in question an amount equal to the Monthly Amortization Amount (defined below) for such Capital Item; provided, however, that, notwithstanding the foregoing, (i) if and to the extent a particular Law Change shall be applicable to (or any existing Applicable Requirements are imposed or invoked which shall be applicable to) (A) the Premises by reason of a special use or occupancy by Tenant of all or any portion of the Premises (which would not otherwise be applicable to the Premises if the Premises were devoted to general warehouse, distribution or light industrial use), (B) any office improvements within the Premises (which are not structural and are not part of the Building systems), or (C) Fixture Work, Tenant's Fixtures or Tenant's personal property, then to such extent, Tenant shall bear all of the Law Change Capital Costs relating to such Law Change or such application of Applicable Requirements, and (ii) to the extent the Law Change Capital Costs resulting from a particular Law Change relate to modification of an Alteration (defined below) of the Improvements (in existence as of the Commencement Date), Tenant shall bear such Law Change Capital Costs without allocation to Landlord of any portion of the Law Change Capital Costs in question. For purposes of clarification, (i) in the event a Law Change is triggered by an Alteration, "Law Change Capital Cost" shall not include any portion of the cost of installing or implementing the Alteration in question which does not relate to effecting compliance with the Law Change in question, and (ii) the only obligations of Landlord under this Lease (other than pursuant to the Work Letter) with respect to compliance with Applicable Requirements in connection with any modification, alteration, change, deletion or improvement to the Improvements are (A) set forth in Paragraph 6.3.1.1, (B) are set forth in the proviso to Paragraph 6.3.1.2(a) or (C) relate to Landlord's obligation to pay Law Change Capital Costs under this Paragraph 6.3.1.2. The "Monthly Amortization Amount" for each Capital Item shall mean the amount necessary to fully amortize, in equal monthly payments (of principal and interest, with interest at an annual interest rate equal to the prime rate as reported by Bank of America NTSA plus two percent (2%) per annum (the "Lending Rate")) over the reasonable useful life of the Capital Item in question. For example, if it is assumed that the Law Change Capital Costs of a particular Capital Item are $10,000, there are 30 full calendar months remaining in the Original Term as of completion of the Capital Item, the reasonable useful life of the Capital Item is 100 full calendar months and the applicable Lending Rate shall be nine percent (9%) per annum, the Monthly Amortization Amount shall be $142.50. (c) In addition, in the event that the reasonable useful life of a particular Capital Item shall extend beyond the Original Term (if the Capital Item in question is completed during the Original Term) or beyond the first Option Term (if it is completed during the first Option Term) and Tenant subsequently extends the Term pursuant to Paragraph 47 (through the end of the first Option Term or the Second Option Term, as the case may be), prior to the commencement of the ensuing Option Term, Tenant shall continue to pay to Landlord in cash during such Option Term (or until the reasonable useful life of the Capital Item in question shall expire, if such expiration shall occur during such Option Term) an amount equal to Monthly Amortization Amount of such Capital Item. 16 Notwithstanding any provision of this Lease to the contrary, in the event a particular Law Change is required by reason of an Alteration to the Improvements proposed or made by Tenant (that would not otherwise be required under Applicable Requirements if such Alteration were not so made or requested) (or in the event such Alteration triggers the imposition of Applicable Requirements in effect on the Commencement Date compliance with which would not otherwise be required if such Alteration were not so made or requested) during the last two (2) years of the Term (which shall include any additional Option Terms for which the Option to Extend with respect thereto has been duly exercised by Tenant) (or in the event such Alteration triggers the imposition of Applicable Requirements in effect on the Commencement Date which would not otherwise be required if such Alteration were not so made or requested), Tenant shall bear the sole cost relating to such Law Change or compliance under any Applicable Requirements relating to (or triggered by) such Law Change. (d) In performing any compliance with law obligations under this Paragraph 6.3, each Party may utilize any "grandfather" exemption, variance, hardship exemption or similar relief mechanism available under the Applicable Requirements. 7. Maintenance; Repairs, Trade Fixtures and Alterations. 7.1 Tenant's Obligations: (a) In General. Subject to the provisions of Paragraphs 6.3, 7.2, 7.3, 9, and 14, and subject to Landlord's obligations under the Work Letter, Tenant shall, at Tenant's sole expense, maintain and repair (and if necessary, replace (other than any Landlord Replacement Items)) in good condition, reasonable wear and tear and the negligence or misconduct of the Landlord Parties (defined in Paragraph 8.7(a)) excepted, the Building, the Improvements and the Premises and every part thereof, including, without limitation, all driveways, landscaping, sidewalks, parking areas, signs, retaining walls, fences, outdoor lighting, walkways, and parkways located on the Land, the Improvements, all Alterations, and all other all systems, equipment, improvements, utility installations and facilities in, on and/or serving the Building and/or Premises (collectively, "Tenant's Maintenance Obligations"). Tenant shall perform Tenant's Maintenance Obligations so as not to render void or inapplicable any warranty (delivered to Tenant) with respect to the Improvements. (b) Landlord's Right to Make Repairs. Without limitation of Paragraphs 13.1 and 13.2 hereof, in the event Tenant fails to perform its maintenance and repair obligations under Paragraph 7.1, such failure shall be deemed a Tenant Default and if such failure continues for thirty (30) days (or in the case of an emergency, one (1) business day) following Tenant's receipt of written notice from Landlord stating with particularity the nature of the failure, Landlord shall have the right to perform such failed obligation of Tenant at Tenant's expense; provided, however, if the nature of the maintenance or repair obligation in question is such that it cannot, with the exercise of reasonable diligence, be completed within thirty (30) days of Tenant's receipt of Landlord's notice, Landlord shall not have the right to undertake any such maintenance or repairs at Tenant's expense, if Tenant commences the maintenance or repairs in question within said 30-day period and thereafter diligently and continuously prosecutes the same to completion. Landlord shall be entitled to prompt reimbursement by Tenant of Landlord's costs and expenses in taking such action, plus interest at the Interest Rate (without any need for further notice referenced in Section 13.4) during the period from the date Landlord incurs such costs and expenses until such time as payment is made by Tenant. (c) Service Contracts. During the Term, Tenant shall, at Tenant's sole cost and expense, procure and maintain service contracts for the HVAC system, the parking lot and the roof in reasonable customary form, and with an qualified contractor approved in advance by Landlord, which approval shall not be unreasonably withheld, conditioned or delayed. 7.2 Landlord's Obligations. (a) Subject to the provisions of Paragraphs 6.3, 7.1, 7.5, 9, and 14, and subject to Landlord's obligations under Work Letter, during the Lease Term, Landlord shall maintain and repair (and if necessary, replace), reasonable wear and tear and the negligence or misconduct of Tenant Parties (defined in Paragraph 8.7(b) excepted, the Building's foundation (excluding flooring and excluding any Fixture Work or Tenant's Trade Fixtures), structural elements of the Building (i.e. footings, load-bearing walls, support steel beams), and structural portions of the Building roof (but not the roof membrane) (collectively, "Landlord Replacement Items"). It is the intention of the Parties that the terms of this Lease govern the respective obligations of the Parties as to maintenance and repair of the Premises, and they expressly waive the benefit of any statute now or hereafter in effect to the extent it is inconsistent with the terms of this Lease. The Parties acknowledge that the foregoing provisions of Paragraphs 7.1 and 7.2 shall not apply to any repairs required as a result of fire or other casualty, which shall be governed by the provisions of Paragraph 9 below. 17 (b) Notwithstanding any provision of this Lease to the contrary, Landlord shall, at its sole cost and expense, (i) repair or cause to be repaired any defects in the labor or materials of the Improvements of which Tenant gives Landlord written notice within one (1) year following the Commencement Date and (ii) use reasonable efforts to enforce any warranty with respect to defects in labor and materials in the Improvements having a warranty period under the Construction Contract (defined in the Work Letter) of longer than one (1) year (where Tenant gives Landlord timely written notice within such warranty period of such defects). 7.3 Capital Repairs and Replacements. (a) Notwithstanding any provision of Paragraph 7.1 to the contrary, but subject to the provisions of Paragraphs 6.3, 7.2, the Work Letter and this Paragraph 7.3, in the event that the performance of any maintenance or repair obligation of Tenant under Paragraph 7.1 shall require the performance of a Capital Item with respect to part of the Improvements, other than with respect to any Excluded Items (as defined in Paragraph 7.3(b) below), the actual out-of-pocket cost and expense of the Party or Parties performing such Capital Item (as to such Capital Item) ("Capital Item Costs") shall be allocated between Landlord and Tenant as follows: (i) Subject to Tenant's obligation to pay the Monthly Amortization Amount for Capital Items under subparagraph (ii) below, and the provisions of Paragraphs 6.3.1.2(b) and 7.3(b), Landlord shall pay for all Capital Item Costs. If Tenant shall perform the Capital Item in question, Landlord shall reimburse Tenant for all Capital Item Costs paid by Tenant to unrelated third parties in connection therewith within thirty (30) days of receipt by Landlord of a written invoice therefor and customary lien waivers in connection therewith (accompanied by reasonable evidence of the expenditure in question); provided, however, that in the case where Tenant shall perform the Capital Item in question, (A) except in the case of an Emergency (in which case Tenant may commence the performance of the Capital Item immediately following delivery to Landlord of one (1) business day's advance written notice), Tenant shall not commence the performance of the Capital Item in question until thirty (30) days (10 days if the Capital Item affects performance of the HVAC system ("HVAC Capital Items")) shall have elapsed following the date that Tenant shall have delivered to Landlord a written description of the Capital Item in question and the nonbinding detailed bids of two (2) qualified contractors for the cost of performing the Capital Item, and (B) Landlord shall have the right, exercisable by delivery of written notice to Tenant during such thirty (30) day period (ten (10) day period in the case of HVAC Capital Items) to elect to perform the Capital Item directly (in which case Landlord shall, during such 30 day period (or 10 day period in the case of HVAC Capital Items) engage a qualified contractor to commence such performance and to thereafter diligently pursue the same to completion). The performance of any Capital Item by Tenant under this Paragraph 7.3(a) shall be conducted in a commercially reasonable manner (as to all aspects thereof, including cost) and so as to not create a Design Problem. (ii) In turn, commencing with the first day of the month the Capital Item in question is completed (with the parties to make a retroactive adjustment if the relevant cost information for calculation of the Monthly Amortization Amount is not immediately available) and continuing on the first day of each calendar month thereafter until the earlier of (A) the expiration of the reasonable useful life of the Capital Item in question and (B) the expiration or earlier termination of this Lease, Tenant shall pay to Landlord, as Additional Rent, an amount equal to the Monthly Amortization Amount (calculated on the basis set forth in Paragraph 6.3.1.2 above) for such Capital Item (and the Capital Item Costs with respect thereto). 18 (b) Notwithstanding any provision of this Paragraph 7.3 to the contrary, Landlord shall not be required to bear any Capital Item Costs (and Tenant shall bear such Capital Item Costs) to the extent the amount of such Capital Item Costs (or the need to perform the Capital Item in question) (i) is due to the failure of Tenant to implement a maintenance program for such Capital Item consistent with commercially reasonable standards and in conformity with this Lease, (ii) relates to any Tenant's Fixtures, Fixture Work or Tenant's personal property, (iii) is due to any negligence or misconduct of Tenant or (iv) relates to the repair or replacement of any Alteration of the original Improvements (as of the Commencement Date) which itself is not a replacement of part of the original Improvements (collectively, the "Excluded Items"). 7.4 Tenant's Right to Make Repairs. (a) If Tenant delivers written notice to Landlord of an event or circumstance which requires the action of Landlord with respect to the Landlord Replacement Items under Paragraph 6.2 or Paragraph 7.2, and Landlord fails to perform such action as required by the terms of this Lease and such failure continues for thirty (30) days (or in the case of an Emergency, one (1) business day) after receipt of such written notice from Tenant, stating with particularity the nature of the failure, Tenant may proceed to take the required action upon delivery of an additional ten (10) business days (or in the case of an Emergency, two (2) business days) notice to Landlord specifying that Tenant is taking such required action; provided however, if the nature of the obligation in question is such that it cannot, with the exercise of reasonable diligence, be completed within thirty (30) days of Landlord's receipt of Tenant's notice, Tenant shall not have the right to undertake any such action at Landlord's expense, if Landlord commences the action in question within said 30-day period and thereafter diligently and continuously prosecutes the same to completion. If Landlord does not deliver a detailed written objection to Tenant within thirty (30) days after receipt of an invoice from Tenant of its costs of taking such required action which Tenant claims should have been taken by Landlord, which invoice from Tenant sets forth a reasonably particularized breakdown of its costs and expenses in connection with taking such action on behalf of Landlord, and if such action was required under the terms of this Lease to be taken by Landlord at Landlord's cost (without obligation for reimbursement (other than amortization payments) from Tenant), then subject to the provisions of Paragraph 7.3, Tenant shall be entitled to prompt reimbursement by Landlord of Tenant's costs and expenses in taking such action plus interest at the Interest Rate applicable to the Monthly Amortization Amount during the period from the date Tenant pays such costs and expenses until such time as payment is made by Landlord. If Landlord does not so reimburse Tenant within thirty (30) days after receipt of an invoice by Tenant of its costs of taking action which Tenant claims should have been taken by Landlord, then without prejudice to Tenant's other rights and remedies Tenant shall be entitled to deduct from all Rent next due and owing by Tenant under this Lease, an amount equal to that set forth in the invoice together with interest thereon at the Interest Rate from the date Tenant incurs such costs until fully deducted from Rent. The term "Emergency" shall mean a condition that creates an imminent, material threat to life or of material damage to property, or material impairment or full interruption of Tenant's business operations in the Premises. (b) In addition, in the event that an amount payable by Landlord to Tenant under Paragraph 6.3 or under Paragraph 7.3 is not paid when due thereunder, such amount shall bear interest at the Interest Rate, and without prejudice to Tenant's other rights and remedies, Tenant shall have the right to deduct such amount from Rent next due and owing hereunder until such amount has been deducted in its entirety. 7.5 Trade Fixtures; Alterations. (a) The term "Trade Fixtures" shall mean Tenant's trade fixtures and equipment (not constituting part of the Improvements and otherwise not paid for by Landlord) installed in the interior of the Building that can be removed without doing damage to the Building (that cannot be reasonably repaired thereafter by Tenant). The term "Alterations" shall mean any modification, alteration of the Improvements or any part thereof (including the Building systems and equipment and all utility and other systems and equipment of or serving the Building and/or Premises), whether by addition or deletion, made following Substantial Completion of the Improvements; provided, that the Work Letter (and not this Paragraph 7.5) shall govern the initial installation of the Fixture Work. Tenant 19 may, without the need to obtain the consent or approval of Landlord, make any Alteration that is interior only and does not affect the Building Systems and Equipment or the Building structural elements, and does not exceed $100,000 in cost. Any other Alteration shall require the consent of Landlord as provided herein. All Alterations requiring the consent of Landlord pursuant to this Lease are referred to herein as "Consent Alterations." For purposes of this Lease, "Design Problem" shall mean any Alteration proposed by Tenant which (a) adversely affects the Building Systems and Equipment or affects the Building structural elements, (b) is not in compliance with Applicable Requirements or (c) affects the exterior appearance of the Building or (d) would render void or inapplicable the provisions of any then effective warranty with respect to the Improvements. Tenant may not make any Consent Alteration without first procuring the prior written consent of Landlord to such Alterations, which consent shall be requested by Tenant not less than fifteen (15) days prior to the commencement thereof, and which consent shall not be unreasonably withheld or conditioned by Landlord. Notwithstanding the foregoing, it shall not be considered unreasonable for Landlord to withhold its consent if and to the extent the proposed Alteration would create or cause a Design Problem. In the event Tenant proposes to make a Consent Alteration, Tenant's notice regarding the proposed Consent Alteration shall include reasonable plans and specifications for the Consent Alteration in question. Landlord shall grant or withhold its consent to any proposed Consent Alterations within fifteen (15) days of receipt of Tenant's notice together with plans and specifications and other supporting documentation describing such Alteration; Landlord's failure to respond within fifteen (15) days of a second notice given after receipt by Tenant of such information and the lapse of such fifteen (15) day period shall be deemed to evidence Landlord's approval with respect to the Consent Alteration for which consent is requested. Tenant shall, at its sole cost and expense, cause to be performed all Alterations in compliance with all Applicable Requirements and in conformity with all applicable warranties. Any Alterations shall be performed at Tenant's sole cost and expense, in a good and workmanlike manner with good and sufficient materials. Landlord shall have the right to inspect and monitor the construction of any Alterations, and Tenant shall promptly upon completion furnish Landlord with as-built plans and specifications for all Alterations. Tenant shall obtain all necessary permits and certificates in connection with any Alteration. (b) Mechanics' Liens. Tenant shall pay, when due, all claims for labor or materials furnished or alleged to have been furnished to or for Tenant at or for use on the Premises (other than any of the same arising out of any work performed by, or at the direction of, Landlord), which claims are secured by any mechanic's or materialmen's lien against the Premises or any interest therein. Tenant shall remove any mechanics' lien, materialmens' lien, stop notice of similar lien or any other encumbrance filed or recorded against the Premises or Landlord's interest therein by bond or otherwise within 30 days after written notice by Landlord. Nothing contained in this Lease shall authorize Tenant to do any act which shall subject Landlord's title to the Building or Premises to any liens or encumbrances whether claimed by operation of law or express or implied contract. 7.6 Ownership; Removal; Surrender; and Restoration: ---------------------------------------------- (a) Ownership. Subject to Landlord's right to require removal as provided in Paragraph 7.6(b) below, all Trade Fixtures and Alterations made by or on behalf of Tenant and not removed by Tenant at the end of the Term shall, at the expiration or termination of this Lease, become the property of Landlord and be surrendered by Tenant with the Premises. (b) Removal. By delivery to Tenant of written notice from Landlord at the time Landlord shall grant its consent thereto, Landlord may require that any or all Consent Alterations be removed by Tenant by the expiration or termination of this Lease and any other Alterations not constituting Consent Alterations made by or on behalf of Tenant that Landlord requests be removed; provided, however, that notwithstanding any provision of this Lease to the contrary, (i) other than the Platform Improvements (which Landlord may require Tenant to remove at the expiration of the Term), Landlord may not require removal of any of the Improvements constructed in the Premises pursuant to the Work Letter (or any reasonable replacement for any of such Improvements) and (ii) Landlord (A) shall not be permitted to require Tenant to remove any Alterations which are general office improvements (to the extent all office improvements not to be removed do not exceed 18,000 square feet in area, are contiguous with the initial office improvements (but not in the mezzanine), or are located in the corners of the Building) or (B) any loading docks (in addition to those provided as part of the original Improvements) which are of the same size as the initial loading docks. 20 (c) Surrender/Restoration. Tenant shall surrender the Premises by the Expiration Date or any earlier termination date, with all of the Improvements, thereof broom clean and free of debris, reasonable wear and tear, damage from casualty resulting in termination of this Lease, condemnation resulting in termination of this Lease and the negligent acts of Landlord excepted. Subject to Paragraph 7.6(a) above, all Trade Fixtures and Tenant's personal property shall remain the property of Tenant and shall be removed by Tenant and Tenant shall repair any damage to the Premises caused thereby. 8. Insurance; Indemnity. 8.1 Payment For Insurance. Tenant shall pay directly for all policies of insurance required to be carried by Tenant pursuant to Paragraphs 8.2(a), 8.4(a) and 8.4(c). Tenant shall reimburse Landlord for its out-of-pocket expenses paid for by Landlord in maintaining the policies of insurance described in Paragraphs 8.2(b), 8.3(a) (subject to the limitations contained therein) and 8.3(b) within thirty (30) days of Tenant's receipt of a reasonably detailed invoice (accompanied by reasonable supporting documentation); provided, however, that premiums for policy periods for insurance maintained by Landlord commencing prior to or extending beyond the Lease Term shall be prorated to correspond to the Lease Term. Tenant shall be liable for any deductible amount in the event of a claim against any insurance policy described in Paragraph 8.2(a), 8.2(b) (provided that Tenant's obligation shall be limited to commercially reasonable deductibles), Paragraph 8.3(b) (subject to the limitations set forth in said Paragraph) and Paragraph 8.4. In addition, Tenant shall within ten (10) days of receipt from Landlord of any invoice therefor (accompanied by reasonable evidence of the costs in question and the deductible requirement in question), pay to Landlord the amount of any deductible suffered by Landlord with respect to a particular loss covered under the All Risk Insurance (defined below); provided, however, that Tenant shall not be required to pay to Landlord more than Twenty Thousand Dollars ($20,000.00) in deductible amounts with respect to any one casualty event. 8.2 Liability Insurance: (a) Carried by Tenant. Tenant shall obtain and keep in force a Commercial General Liability policy of insurance in customary form (a "CGL Policy" or "CGL Insurance") protecting against claims for bodily injury, personal injury and property damage based upon or arising out of the use, occupancy or maintenance of the Premises and all areas appurtenant thereto. Such insurance shall be on an occurrence basis providing single limit coverage in an amount not less than $5,000,000 per occurrence with an "Additional Insured-Managers or Landlords of Premises Endorsement" and an "Amendment of the Pollution Exclusion Endorsement" for damage caused by heat, smoke or fumes from a hostile fire, naming Landlord, its agents, affiliates, assignees and lenders as Additional Insureds. The policy shall not contain any intra-insured exclusions as between insured persons or organizations, but shall include coverage to the extent customary for liability assumed under this Lease as an "insured contract" for the performance of Tenant's indemnity obligations under this Lease. The limits of said insurance shall not, however, limit the liability of Tenant nor relieve Tenant of any obligation hereunder. All liability insurance carried by Tenant shall be primary to and not contributory with any similar insurance carried by Landlord, whose insurance shall be considered excess insurance only. (b) Carried by Landlord. Landlord shall maintain, at Tenant's cost (pursuant to Paragraph 8.1), a CGL Policy in the form and amount as described in Paragraph 8.2(a) (with Landlord to have the right to have deductibles with respect thereto), in addition to, and not in lieu of, the insurance required to be maintained by Tenant. 21 8.3 Property Insurance of Building and Improvements. (a) Landlord shall obtain and keep in force, at Tenant's cost, a policy or policies of "All Risk" insurance ("All Risk Insurance") in the name of Landlord, with loss payable to Landlord and any Lenders insuring loss or damage to the Improvements (including without limitation, all Alterations thereto), provided, however, that notwithstanding the foregoing, such All Risk Insurance shall not cover Tenant's Trade Fixtures, Fixture Work and Tenant's personal property, which items shall be insured by Tenant under Paragraph 8.4 below. The amount of such All Risk Insurance to be obtained by Landlord shall be equal to the full replacement cost of the Improvements, as the same shall exist from time to time, but in no event more than the commercially reasonable and available insurable value thereof. Subject to the provisions of this Paragraph 8.3, if and to the extent the coverage is reasonably available at a commercially reasonable cost, such policy or policies shall (i) insure against all risks of direct physical loss or damage, including coverage for flood, debris removal and the enforcement of any Applicable Requirements requiring the upgrading, demolition, reconstruction or replacement of any portion of the Improvements as the result of a covered loss, and (ii) waivers of subrogation. Notwithstanding any provision of this Lease to the contrary, Landlord may (but shall not be required to) maintain coverage for damage to the Improvements by earthquake or any other risk of loss not typically covered under an All Risk Insurance policy (collectively, the "Excluded Risks") but if Landlord elects to maintain such coverage, Tenant shall not be required to reimburse (directly or indirectly) Landlord for any deductible with respect to the Excluded Risks or for any portion of the cost of such coverage exceeding Twelve Thousand Dollars ($12,000.00) per year. (b) Landlord shall also carry rental loss insurance (in customary form) providing coverage for losses in Rent hereunder, for a period not to exceed twelve (12) months, resulting from damage to the Premises by reason of a casualty risk required to be covered under the All Risk Insurance policy to be obtained by Landlord under Paragraph 8.3(a). 8.4 Tenant's Insurance: (a) Property Damage. Tenant shall obtain and maintain All Risk Insurance coverage on all of Tenant's personal property, Fixture Work and Trade Fixtures in or about the Premises. Such insurance shall be full replacement cost coverage, with reasonable deductibles. (b) No Representation of Adequate Coverage. Landlord makes no representation that the limits or forms of coverage of insurance specified herein are adequate to cover Tenant's property, business operations or obligations under this Lease. (c) Additional Insurance. If at any time during the Lease Term, Tenant or any subtenant or assignee of Tenant conducts operations in, on or about the Premises involving boilers, pressure apparatus or other equipment the operation of which is generally covered by "boiler and pressure apparatus liability insurance," and if at that time, most comparable tenants in Comparable Buildings are required to provide such insurance coverage under comparable circumstances, Tenant shall procure and maintain in full force and effect with respect to the Premises, boiler and pressure apparatus liability insurance in reasonably customary form and amount. 8.5 Insurance Policies. Insurance required herein shall be by companies maintaining during the policy term a "General Policyholders Rating" of at least B+VII, as set forth in the most current issue of "Best's Insurance Guide." Tenant shall not do or knowingly permit to be done anything which invalidates the required insurance policies (or shall bear the cost of any increase in premium resulting therefrom). Tenant shall, prior to entry on the Premises (and in all events no later than the Commencement Date), deliver to Landlord certificates evidencing the existence and amounts of the insurance required to be carried by Tenant hereunder. Tenant shall, at least thirty (30) days prior to the expiration of such policies, furnish Landlord with evidence of renewals or "insurance binders" evidencing renewal thereof. All certificates of insurance to be provided hereunder shall contain an endorsement that the insurer thereunder shall endeavor to notify each insured and additional insured thereunder thirty (30) days in advance of any cancellation of the policy in question. Such policies shall be for a term of at least one (1) year, or the length of the remaining Lease Term, whichever is less. 22 8.6 Waiver of Subrogation. Without affecting any other rights or remedies, Tenant and Landlord each hereby release and relieve the other, and waive their entire right to recover damages against the other, for loss of or damage to its property arising out of or incident to the perils required to be insured against under Paragraphs 8.3 and 8.4(a). The effect of such releases and waivers is not limited by the amount of insurance carried or required, or by any deductibles applicable hereto. The Parties agree to have their respective All Risk property damage insurance carriers waive any right to subrogation that such companies may have against Landlord or Tenant, as the case may be. 8.7 Indemnification and Waiver. (a) Waiver. Subject to the provisions of this Lease, Tenant hereby assumes all risk of damage to property or injury to persons in or upon the Premises from any cause whatsoever and agrees that Landlord, its partners and their respective lenders, officers, agents, servants, and employees (collectively, the "Landlord Parties") shall not be liable for any damage either to person or property or resulting from the loss of use thereof, which damage is sustained by Tenant or by other persons claiming through Tenant, except to the extent caused by Landlord's default under this Lease or the negligence or willful misconduct of Landlord or any of the Landlord Parties (provided, however, that Landlord shall not be responsible for any damage to the extent such damage is covered by insurance required to be carried by Tenant under this Lease). (b) Tenant's Indemnity. Subject to the provisions of this Lease, Tenant shall indemnify, defend, protect, and hold harmless Landlord and the Landlord Parties from any and all claims, loss, cost, damage, expense and liability (including without limitation court costs and reasonable attorneys' fees) (collectively, "Costs and Damages") incurred in connection with or arising from (1) any cause in or on the Premises following the Commencement Date prior to the expiration of the Term (or any holdover period, whichever later occurs) or any holdover period (to the extent coverable under the type of CGL Insurance required to be carried by Tenant under Paragraph 8.2(a)) or (2) subject to the terms of the last sentence of Paragraph 8.7(c) below, any negligence or willful misconduct of Tenant or any person claiming by, through or under Tenant, its partners, sublessees, licensees and their respective officers, agents, contractors, and employees (collectively, "Tenant Parties") (whether or not coverable by Tenant's insurance) or (3) any default by Tenant under this Lease, in or on or about the Premises during the Lease Term, provided that, except as set forth below, the terms of the foregoing indemnity shall not apply to the extent such Claims, Costs and Damages arise from the negligence or willful misconduct of Landlord or any of the Landlord Parties. Notwithstanding the foregoing, because Tenant must carry insurance pursuant to Paragraph 8.4(a)) above to cover its personal property and all Trade Fixtures within the Premises, Tenant hereby agrees to protect, defend, indemnify and hold Landlord harmless from any Claim, Cost or Damage with respect to any such property within the Premises, to the extent such Claim, Claims and Damages are coverable by customary All Risk Insurance, even if resulting from the negligence or willful misconduct of Landlord or the Landlord Parties. (c) Landlord's Indemnity. Landlord shall indemnify, defend, protect, and hold harmless Tenant and the Tenant Parties from any and all Claims, Costs and Damages incurred in connection with or arising from (i) any negligent acts or willful misconduct of Landlord or any of the Landlord Parties in, on, or about the Premises (subject to the terms of the last sentence of Paragraph 8.7(b) above) prior to the expiration of the Term (or any holdover period, whichever later occurs) (or) (ii) any default by Landlord under this Lease provided that, except as set forth below, the terms of the foregoing indemnity shall not apply to the extent such Claims, Costs and Damages arise from the negligence or willful misconduct of Tenant or the Tenant Parties in connection with the Tenant Parties' activities in, on, or about the Premises. Notwithstanding the foregoing, because Landlord is required to maintain pursuant to the terms of Paragraph 8.3(a) above All Risk Insurance on the Improvements, Landlord hereby agrees to protect, defend, indemnify and hold Tenant harmless from any Claims, Costs and Damages (exclusive of deductibles to the extent to be borne by Tenant pursuant to Paragraph 8.1) with respect to the Improvements to the extent such Claims, Costs and Damages are covered by the All Risk Insurance required to be carried by Landlord under Paragraph 8.3(a), even if resulting from the negligent acts or willful misconduct of Tenant or the Tenant Parties. 23 (d) Waiver of Consequential Damages. Notwithstanding any provision of this Lease to the contrary, neither Landlord nor Tenant shall be liable to the other Party for any consequential damages for any breach or default (or any other matter) under this Lease, provided that this sentence shall not be applicable to any consequential damages which may be incurred by Landlord relating to or in connection with any holdover by Tenant following the expiration of the Lease Term, subject to and in accordance with the provisions of Paragraph 26 hereof. 8.8 Survival. Each Party's agreement to indemnify and hold the other Party harmless pursuant to Paragraph 8.7 above is not intended to and shall not relieve any insurance carrier of its obligations under policies required to be carried pursuant to the provisions of this Lease. The foregoing provisions of this Paragraph 8 shall survive the expiration or earlier termination of this Lease. 9. Damage or Destruction. 9.1 Definitions: (a) "Premises Damage" shall mean damage or destruction to the Improvements (including, without limitation, and all Alterations), other than the Tenant's Trade Fixtures, Fixture Work and personal property. (b) "Insured Loss" shall mean damage or destruction to Improvements (including, without limitation, all Alterations), other than Tenant's Trade Fixtures, Fixture Work and personal property, which is caused by an event required to be covered by the All Risk Insurance described in Paragraph 8.3(a), irrespective of any deductible amounts or coverage limits involved. (c) "Restoration Cost" shall mean the cost to repair or rebuild the Improvements (including, without limitation, all Alterations) (other than Tenant's Trade Fixtures, Fixture Work and personal property) at the time of the damage and destruction thereof to their condition existing immediately prior to such damage, including demolition, debris removal and upgrading required by the operation of Applicable Requirements, and without deduction for depreciation. 9.2 Restoration. Subject to the provisions of Paragraphs 9.3, 9.4 and 9.5, if, during the Term, there is any Premises Damage to any portion of the Improvements (but not Tenant's Trade Fixtures, Fixture Work or personal property, which shall be Tenant's obligation to repair at Tenant's sole cost and expense) then Landlord shall, at Landlord's expense subject to Paragraph 9.3(a), promptly and diligently repair and restore the Improvements so damaged to the condition of such Improvements in existence immediately prior to such damage as soon as reasonably possible and this Lease shall continue in full force and effect; provided, however, that Tenant shall, at Tenant's election, make the repair of any damage or destruction to the Improvements the total Restoration Cost of which is reasonably estimated by Tenant to be Ten Thousand Dollars ($10,000.00) or less, and, in such event following ten (10) days prior written notice to Landlord (to the extent Landlord is required to pay for or perform such item under the Lease), Landlord shall reimburse Tenant for all Restoration Costs (not exceeding $10,000 per casualty event) incurred by Tenant with respect to such repair within thirty (30) days of Landlord's receipt of a reasonably detailed invoice therefor (accompanied by reasonable supporting documentation). Landlord shall be entitled to the full proceeds of any insurance coverage for the Improvements, whether carried by Landlord or Tenant, for damage to the Premises. Notwithstanding anything to the contrary contained herein, in the event (and to the extent) of (i) the occurrence of damage or destruction to the Premises that requires the repair or restoration of any Alteration (to the extent the same is not just a replacement of an original Improvement) and (ii) the cost of such repair or restoration is not covered by the insurance required to be carried by Landlord (or otherwise carried by Landlord), Landlord shall not be required to undertake or bear the cost of such repair or restoration. 24 9.3 Landlord Right to Terminate. (a) In the event that there is any Premises Damage to any portion of the Improvements during the Term which is not an Insured Loss under circumstances where the Restoration Cost of such damage to the Improvements (not otherwise covered by insurance proceeds or funds provided by Tenant) exceeds (a "Restoration Cost Deficiency") Five Hundred Thousand Dollars ($500,000.00), which amount shall be reduced to $250,000.00 in the last two years of the Term (the "Damage Threshold"), Landlord shall have the right, exercisable by delivery to Tenant of written notice of termination within seventy-five (75) days of Landlord's discovery of the Premises Damage in question, to terminate this Lease effective upon the date sixty (60) days following delivery to Tenant of such notice of termination (which notice shall describe in reasonable detail the grounds for such termination (and attach reasonable supporting documentation therefor)); provided, however, that in the event Tenant shall receive any such notice of termination, (i) Tenant shall have the right (but not the obligation) to render such termination of this Lease void and ineffective (and to reinstate this Lease in full force and effect) by delivering to Landlord, within thirty (30) days of Tenant's receipt of Landlord's notice of termination, Tenant's written agreement to contribute (together with evidence of the security for such payment if reasonably required by Landlord), at Tenant's expense, the funds required to reduce the applicable Restoration Cost Deficiency to an amount equal to the Damage Threshold, and (ii) in any case, Tenant shall have the right to extend the effective date of any such termination for up to sixty (60) additional days (as selected by Tenant) by delivery of written notice to Landlord within thirty (30) days of Tenant's receipt of Landlord's notice of termination. (b) If, at any time during the last two (2) years of the Term (which shall include any Option Term for previously exercised Options to Extend; provided, that Tenant may exercise any remaining unexercised Option to Extend (in accordance with Paragraph 47 hereof) within thirty (30) days of receipt of Landlord's notice under this Paragraph 9.3(b) and in such case, the Option Term with respect thereto shall also be included), there is any Premises Damage, rendering at least twenty-five percent (25%) of the Improvements untenantable and its repair or restoration requires more than one hundred twenty-(120) days to complete, then Landlord may terminate this Lease at any time within ninety (90) days of Landlord's discovery of the damage effective ninety (90) days following the date of delivery to Tenant of a written notice of termination. 9.4 Tenant's Right to Terminate. Tenant shall have the right to terminate this Lease (a) in the event at any time during the Term there occurs any Premises Damage to any portion of the Improvements by any form of casualty event which (i) renders, more than thirty-five percent (35%) of the Improvements untenantable or inoperable for the operation of Tenant's business and (ii) cannot reasonably be fully restored to its condition existing immediately prior to such damage or destruction within eleven (11) months of both Landlord's and Tenant's discovery of the Premises Damage in question, which right shall be exercisable by Tenant by delivery to Landlord of written notice of termination (which shall specify the effective date of termination, which may be up to 120 days following the date of delivery of the notice) at any time within ninety (90) days after Landlord's discovery of the damage, and (b) if at any time during the last two (2) years of the Lease Term, there is any Premises Damage rendering at least twenty-five percent (25%) of the Improvements untenantable and its repair or restoration requires more than one hundred twenty (120) days to complete, Tenant may terminate this Lease at any time within ninety (90) days of Tenant's discovery of such damage by delivery to Landlord of up to ninety (90) (but not less than thirty (30)) days' written notice of termination. 9.5 Abatement of Rent; Tenant's Remedies. (a) Abatement of Rent. If the Premises or the Improvements are partially or totally destroyed or damaged by any casualty event, Base Rent and Additional Rent shall be abated in proportion to the degree of interference and disruption of Tenant's use and enjoyment of the Premises from the date such damage or destruction occurs until the date the repair or restoration of the Improvements is substantially complete. 25 (b) Remedies. If Landlord shall be obligated to repair or restore the Premises and/or the Improvements under this Paragraph 9 and does not commence, in a substantial and meaningful way, such repair or restoration within seventy-five (75) days after such obligation shall accrue, and such failure shall continue for ten (10) days following delivery by Tenant to Landlord and such Lenders of written notice of such failure, Tenant shall have the right to elect to perform the Landlord's restoration obligations, in which case, Tenant shall be reimbursed by Landlord within thirty (30) days of Tenant's written request therefor, for all of the Tenant's good faith costs and expenses incurred in performing such obligations or Tenant may, at any time prior to the commencement of such repair or restoration, give written notice to Landlord and to any Lenders of which Tenant has actual notice, of Tenant's election to terminate this Lease on a date (selected by Tenant) not less than thirty (30) days following the giving of such notice. If Tenant gives such notice and such repair or restoration is not commenced within thirty (30) days thereafter, this Lease shall terminate as of the date specified in said notice. If the repair or restoration is commenced within said thirty (30) day period, this Lease shall continue in full force and effect. The term "commence" under this Paragraph 9.5(b) shall mean either the unconditional authorization of the preparation of the required plans, or the beginning of the actual work on the Premises, whichever first occurs. In addition, if neither Landlord nor Tenant elect to terminate this Lease and the casualty damage in question has not been repaired within twelve (12) months after the date of notice from Tenant to Landlord of the discovery of damage (subject to Force Majeure and delays caused by Tenant), then Tenant shall have the right, within five (5) business days of the end of such period, and thereafter during the first five (5) business days of each calendar month following the end of such period until such time as the repairs in question are completed, to terminate this Lease by notice to Landlord (the "Damage Termination Notice"), effective as of a date set forth in the Damage Termination Notice (the "Damage Termination Date"), which Damage Termination Date shall not be less than five (5) business days following the end of such period or each such month, as the case may be. Notwithstanding the foregoing, if Tenant delivers a Damage Termination Notice to Landlord, then Landlord shall have the right to suspend the occurrence of the Damage Termination Date for a period ending thirty (30) days after the delivery by Tenant of the Damage Termination Notice by delivering to Tenant, within five (5) business days of Landlord's receipt of the Damage Termination Notice, a certificate of Landlord's contractor responsible for the repair of the damage certifying that it is such contractor's good faith judgment that the repairs shall be substantially completed, within thirty (30) days after delivery by Tenant of the Damage Termination Notice. If such repairs shall be substantially completed prior to the expiration of such 30-day period, then the Damage Termination Notice shall be of no force or effect, but if the repairs are not substantially completed within such 30-day period, then this Lease shall terminate upon the expiration of such 30-day period. 9.6 Termination-Advance Payments. Upon termination of this Lease pursuant to this Paragraph 9, an equitable adjustment shall be made concerning advance Base Rent and any other advance payments made by Tenant to Landlord. 9.7 Waive Statutes. Landlord and Tenant agree that the terms of this Lease shall govern the effect of any damage to or destruction of the Premises and hereby waive the provisions of any present or future statute to the extent inconsistent herewith, including California Civil Code Sections 1932(2) and 1933(4). 9.8 Notification. Tenant shall give prompt written notice to Landlord of any fire or other casualty to any part of the Premises of which any of Tenant's onsite management or Tenant's executive management has actual knowledge. 26 10. Real Property Taxes. 10.1 Definition of Real Property Taxes. 10.1.1 Inclusions. Subject to the provisions of Paragraph 10.1.2, as used herein, the term "Real Property Taxes" shall include any form of assessment; real estate, general, special, ordinary or extraordinary, or rental levy or tax (other than inheritance, personal income or estate taxes); and/or license fee imposed upon or levied against any legal or equitable interest of Landlord in the Premises, Landlord's right to other income therefrom, and/or Landlord's business of leasing, by any authority having the power to tax and where the funds are generated with reference to the Premises address and where the proceeds so generated are to be applied by the city, county or other local taxing authority of a jurisdiction within which the Premises is located. The term "Real Property Taxes" shall also include any tax, fee, levy, assessment, penalty, or charge, or any increase therein, imposed by reason of events occurring during the Lease Term, including but not limited to, a change in the ownership of the Premises, or any portion thereof, and/or any improvements constructed on or at the Premises. 10.1.2 Exclusions. Notwithstanding any provision of this Lease to the contrary, in no case shall Real Property Taxes include any of the following: (i) any excess profits taxes, franchise taxes, gift taxes, capital stock taxes, inheritance or succession taxes, estate taxes, federal and state income taxes, or any other taxes to the extent applicable to Landlord's general or net income (as opposed to rents or receipts), (ii) penalties incurred as a result of Landlord's negligence, inability or unwillingness to make payments of, and/or to file any tax or informational returns with respect to, any Real Property Taxes, when due (unless due to Tenant's failure to pay), or (iii) any special assessments or other taxes from any city, county, state or federal government or agency or quasi-governmental agency), participation in which is voluntary (and when Tenant has not consented in writing to such participation, in the exercise of its sole discretion). 10.2 Payment of Taxes. Tenant shall pay the Real Property Taxes applicable to the Premises during the Lease Term. All such payments shall be made prior to any delinquency date therefor; provided that Landlord shall provide to Tenant all bills for such Real Property Taxes (not separately provided to Tenant) not less than thirty (30) days prior to the delinquency date therefor. Tenant shall promptly furnish Landlord with reasonable evidence that such taxes have been paid. If any such Real Property Taxes shall cover any period of time prior to or after the expiration or termination of this Lease, such Real Property Taxes shall be prorated to cover only that portion of the period that this Lease is in effect, and Landlord shall reimburse Tenant (within thirty (30) days of such expiration or termination) for any overpayment. If Tenant shall fail to pay any required Real Property Taxes in accordance with this Paragraph 10.2, except where Tenant is contesting the same in good faith, and such failure continues for thirty (30) days after delivery to Tenant by Landlord of written notice of such failure, Landlord shall have the right to pay the same, and Tenant shall reimburse Landlord therefor within thirty (30) days of receipt of demand therefor. Tenant shall have the right to contest in good faith Real Property Taxes applicable to the Premises, provided no penalties, interest or liens are assessed against the Premises (or Tenant shall agree to indemnify Landlord for the same). 10.3 Joint Assessment. If the Premises are not separately assessed, Tenant's liability shall be an equitable proportion of the Real Property Taxes for all of the land and improvements included within the tax parcel assessed. Landlord and Tenant shall reasonably cooperate to cause the Premises to be separately assessed from all other real property owned by Landlord. 10.4 Personal Property Taxes. Tenant shall pay, prior to delinquency, all taxes assessed against and levied upon the Trade Fixtures, and all furnishings, equipment and personal property of Tenant. When reasonably possible, Tenant shall cause such property to be assessed and billed separately from the real property of Landlord. 27 11. Utilities. Subject to the provisions of the Work Letter, Tenant shall be solely responsible for providing the Premises with, and for paying for, all water, gas, heat, light, power, telephone, telecommunication, trash disposal, sewer and other utilities and services required or desired for the Premises, together with any taxes thereon; provided, however, that in all cases Landlord shall reasonably cooperate with Tenant's efforts to procure any utility services desired by Tenant. Tenant shall contract directly with and pay directly to the utility companies and service providers for such utilities and services. 12. Assignment and Subletting. 12.1 Landlord's Consent Required: (a) Subject to the provisions of this Paragraph 12, Tenant shall not voluntarily or by operation of law assign, transfer, mortgage or encumber (collectively, "assign or assignment") or sublet all or any part of Tenant's interest in this Lease or in the Premises without Landlord's prior written consent, which consent shall not be unreasonably withheld, conditioned or delayed. No consent by Landlord to a particular assignment, sublease or mortgage shall constitute consent or approval of any subsequent assignment, sublease or mortgage. Notwithstanding anything to the contrary contained in this Paragraph 12, in no event may Tenant assign, sublease or license this Lease or the Premises to any entity whatsoever if, at the time of such assignment, mortgage, transfer, pledge or sublease, Tenant is in Breach under this Lease (and such Breach remains uncured). No consent by Landlord to any assignment or sublease shall be deemed to release Tenant from its obligations hereunder and Tenant shall remain fully liable for performance of all obligations under this Lease. (b) Except as expressly provided in Paragraph 12.1(c) below, a change in the control of Tenant shall constitute an assignment requiring Landlord's consent; provided, however that the provisions of this Paragraph 12.1(b) shall not apply (and such change of control shall not constitute an "assignment" hereunder) in the case of any transfers in stock or other interests in Tenant occurring at any time during which Tenant is publicly traded on any national or regional stock or securities exchange or on any over-any-counter market (a "Reporting Company"). The transfer, on a cumulative basis, of all legal and beneficial title and interest in and to fifty percent (50%) or more of the outstanding voting stock of Tenant within a single twelve (12) month period shall constitute a change in control for this purpose. (c) Notwithstanding any provision of this Lease to the contrary, Tenant may assign this Lease or sublease all or part of the Premises without receipt of Landlord's consent, (and without application of any provision of this Paragraph 12) to an entity which acquires all or substantially all of the stock or assets of Tenant, an entity which is the resulting entity of a merger or consolidation of Tenant with another entity, or an entity which is controlled by, controls, or is under common control with, Tenant (each of such entities shall be referred to hereinafter as an "Affiliate"), so long as: (i) any such sublease or assignment shall be subject and subordinate to the terms and provisions of this Lease; (ii) any such Affiliate assignee assumes in a writing delivered to Landlord all of the obligations of Tenant accruing after the effective date of the assignment under this Lease; and (iii) no such assignment or sublease shall release Tenant from any of its obligations under this Lease. "Control" as used in this Paragraph 12 (c) shall mean the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person or entity, or ownership of any sort. Tenant shall notify Landlord of any such assignment or sublease promptly following consummation of such transaction. (d) Any assignment or subletting for which Landlord's consent is required under this Paragraph 12 (a "Consent Transfer") effected without Landlord's consent hereunder shall be a Default (as defined in Paragraph 13.1 below) curable after notice to Tenant pursuant to Paragraph 13.1(c). (e) Upon prior written notice to Landlord, Tenant may also allow any person or company which is a client or customer of Tenant or which is providing service to Tenant or one of Tenant's clients to occupy as a licensee or sublessee portions of the Premises without such occupancy being deemed a sublease or license transaction governed by this Paragraph 12, as long as: (i) all such occupancies shall not occupy, in the aggregate, more than twenty percent (20%) of the Building; (ii) such occupancy shall be subject and subordinate to the terms and provisions of this Lease; and (iii) no such occupancy shall release Tenant from any of its obligations under this Lease. 28 12.2 Terms and Conditions Applicable to Assignment and Subletting: (a) Regardless of Landlord's consent, any assignment or subletting shall not release Tenant of any obligations hereunder. (b) Landlord may accept Rent or performance of Tenant's obligations from any person other than Tenant pending approval or disapproval of an assignment. No acceptance of Rent or performance shall constitute a waiver or estoppel of Landlord's right to exercise its remedies for Tenant's Default or Breach (as defined in Paragraph 13.1 below). (c) Landlord's consent to any assignment or subletting shall not constitute a consent to any subsequent assignment or subletting. (d) Each request for Landlord's consent to a Consent Transfer shall be in writing, accompanied by reasonable customary information including, without limitation, information regarding the financial responsibility of the proposed assignee or subtenant accompanied by a term sheet or other written description of the primary economic terms of the proposed Consent Transfer ("Transfer Notice"). Tenant shall promptly provide a copy of the sublease or assignment documents to Landlord upon execution thereof. (e) Notwithstanding any provision of this Lease to the contrary, (i) Landlord may not withhold its consent to any Consent Transfer on the basis of (A) the economic terms of the proposed Consent Transfer except relating to the transferee's financial condition or (B) the fact that the terms of the Consent Transfer shall permit further subleasing, subject to compliance with the provisions of this Paragraph 12 and (ii) any request for Landlord's consent to a Consent Transfer conforming to the provisions of Paragraph 12.2(d) with respect to which no written response from Landlord is received by Tenant within ten (10) days following submission to Landlord by Tenant of such request for consent (and accompanying information described in clause (d) above) shall conclusively be deemed approved and consented to by Landlord. (f) Notwithstanding any provision of this Lease to the contrary, in no case shall Landlord be permitted (or have the right to require Tenant to agree to allow Landlord) (as a condition of its consent to a Consent Transfer or otherwise) to physically recapture any space proposed to be sublet or assigned or to share in any of the proceeds or profits of any such assignment or sublease. (g) If Landlord consents to any proposed Consent Transfer pursuant to the terms of this Paragraph 12, Tenant may within six (6) months after Landlord's consent, but not later than the expiration of said six-month period, enter into such Consent Transfer upon substantially the same terms and conditions as are set forth in the Transfer Notice furnished by Tenant to Landlord requesting Landlord's consent to such assignment or subletting, provided that if there are any material changes in the terms and conditions from those specified in such notice such that Landlord would initially have been entitled to refuse its consent to such assignment or subletting under this Paragraph 12, Tenant shall again submit the assignment or subletting to Landlord for its approval, under Paragraph 12.2. 13. Default; Breach; Remedies. 13.1 Default; Breach. A "Default" is defined as a failure by the Tenant to comply with or perform any of the provisions of this Lease. A "Breach" is defined as the occurrence of one or more of the following Defaults, and the failure of Tenant to cure such Default within the applicable grace period (following delivery of written notice to Tenant) set forth below: 29 (a) The failure of Tenant to make any payment of Rent required to be made by Tenant hereunder, to Landlord, when due, where such failure continues for a period of five (5) business days following delivery of written notice of such failure to Tenant. (b) The failure by Tenant to provide (i) subordination documents conforming to the requirements of Paragraph 30, or (ii) an "Estoppel Certificate" (defined in Paragraph 16(a) below) conforming to the requirements of Paragraph 16, where any such failure continues for a period of ten (10) business days following delivery to Tenant of written notice of such failure by Landlord. (c) A Default by Tenant, other than those described in Paragraphs 13.1(a) or (b), where such Default continues for a period of thirty (30) days after delivery by Landlord of written notice of such Default; provided, however, that if the nature of Tenant's Default is such that more than thirty (30) days are reasonably required for its cure, then the same shall not be deemed to be a Breach if Tenant commences such cure within said thirty (30) day period and thereafter diligently prosecutes such cure to completion, provided however, if a Default under this clause (c) relates to an Arbitration Matter (defined below) and is subject to dispute as to whether such Default exists, then such determination shall be subject to arbitration under Paragraph 48 hereof. All notices to be given pursuant to this Paragraph 13.1 shall be in addition to, and not in lieu of, the notice requirements of California Code of Civil Procedure Section 1161. 13.2 Remedies. In the event of a Breach, Landlord may, with or without further notice or demand, and without limiting Landlord in the exercise of any right or remedy which Landlord may have by reason of such Breach: (a) Terminate Tenant's right to possession of the Premises by any lawful means, in which case this Lease shall terminate and Tenant shall immediately surrender possession to Landlord. In such event Landlord shall be entitled to recover from Tenant: (i) the unpaid Rent which had been earned at the time of termination; (ii) the worth at the time of award of the amount by which the unpaid Rent which would have been earned after termination until the time of award exceeds the amount of such rental loss that the Tenant proves could have been reasonably avoided; (iii) the worth at the time of award of the amount by which the unpaid Rent for the balance of the term after the time of award exceeds the amount of such rental loss that the Tenant proves could be reasonably avoided; and (iv) any other amount reasonably necessary to compensate Landlord for all the detriment proximately caused by the Tenant's failure to perform its obligations under this Lease or which in the ordinary course of things would be likely to result therefrom, including but not limited to the cost of recovering possession of the Premises, expenses of reletting, including necessary renovation and alteration of the Premises, and reasonable attorneys' fees. In the event Landlord terminates this Lease pursuant to Paragraph 13.2(a), Landlord shall use reasonable efforts to mitigate damages. The worth at the time of award of the amount referred to in clauses (i) and (ii) above shall be calculated with interest at the Interest Rate. The worth at the time of award of the amount referred to in clause (iii) above shall be computed by discounting such amount at the discount rate of the Federal Reserve Bank of the District within which the Premises are located at the time of award plus one percent (1%). Efforts by Landlord to mitigate damages caused by Tenant's Breach of this Lease shall not waive Landlord's right to recover damages under this Paragraph 13. If termination of this Lease is obtained through the provisional remedy of unlawful detainer, Landlord shall have the right to recover in such proceeding any unpaid Rent and damages as are recoverable therein, or Landlord may reserve the right to recover all or any part thereof in a separate suit. (b) Landlord shall have the remedy set forth in California Civil Code Section 1951.4; i.e., Landlord may continue the Lease and Tenant's right to possession and recover the Rent as it becomes due. 30 (c) Pursue any other remedy now or hereafter available under the laws or judicial decisions of the state wherein the Premises are located. The expiration or termination of this Lease and/or the termination of Tenant's right to possession shall not relieve Tenant from liability under any indemnity provisions of this Lease as to matters occurring or accruing during the Lease Term hereof or by reason of Tenant's occupancy of the Premises. 13.3 Late Charges. Tenant hereby acknowledges that late payment by Tenant of Rent will cause Landlord to incur costs not contemplated by this Lease, the exact amount of which will be extremely difficult to ascertain. Such costs include, but are not limited to, processing and accounting charges, and late charges which may be imposed upon Landlord by any Lender. Accordingly, if (a) any regularly scheduled monthly payment of Rent shall not be received by Landlord within ten (10) days after the same is due, then, without any requirement for notice to Tenant, Tenant shall pay to Landlord a one-time late charge equal to three and one-half percent (3-1/2%) of each such overdue amount; provided, however, that in the case of the first such late payment during any twelve (12) month period, such late charge shall not be due unless Tenant's delinquency with respect thereto continues for five (5) days after written notice thereof is delivered to Tenant (without the requirement for the ten (10) day period referenced above) and (b) any other form of Rent shall not be received by Landlord within ten (10) days after receipt by Tenant of written notice that such amount is delinquent, Tenant shall pay to Landlord a one-time late charge equal to three and one-half percent (3 1/2%) of such overdue amount. The parties hereby agree that such late charge represents a fair and reasonable estimate of the costs Landlord will incur by reason of such late payment. Acceptance of such late charge by Landlord shall in no event constitute a waiver of Tenant's Default or Breach with respect to such overdue amount, nor prevent the exercise of any of the other rights and remedies granted hereunder. 13.4 Interest. Any monetary payment due Landlord hereunder, other than late charges, not received by Landlord, when due as to scheduled payments (such as Base Rent) or within thirty (30) days following the date on which Landlord delivers to Tenant written notice that the same is delinquent, shall bear interest from the date when due, as to scheduled payments, or the thirty-first (31st) day after it was due as to non-scheduled payments. The interest ("Interest") charged shall be equal to the prime rate reported in the Wall Street Journal as published closest prior to the date when due plus three and one half percent (3.5%) ("Interest Rate"), but shall not exceed the maximum rate allowed by law. 13.5 Default by Landlord. The occurrence of any of the following shall constitute a material default (a "Landlord Default") of this Lease by Landlord: (i) any failure by Landlord to make any payment required to be made by Landlord hereunder when due, where such failure continues for thirty (30) days after delivery of written notice of such failure by Tenant to Landlord or (ii) any material failure by Landlord to perform or comply with any other material provision of this Lease, to be performed or complied with by Landlord, where such failure continues for thirty (30) days after delivery of written notice of such failure by Tenant to Landlord; provided, however, that if the nature of such default is such that the same cannot reasonably be cured within such thirty (30) day period, there shall not be a Landlord Default if Landlord shall, within thirty (30) days of such notice, commence such cure, and thereafter diligently prosecute such cure to completion. 14. Condemnation. 14.1 Generally. If the Premises is taken under the power of eminent domain or sold under the threat of the exercise of said power (collectively "Condemnation"), this Lease shall terminate as to the part taken as of the date the condemning authority takes title or possession, whichever first occurs. In the event of a Condemnation which permanently leaves an insufficient portion of the Premises for the operation of Tenant's business from the Premises, Tenant may, at Tenant's option, which shall be exercised in writing within ninety (90) days after Tenant shall have received written notice of such taking (or in the absence of such notice, within ninety (90) days after the condemning authority shall have taken possession) terminate this Lease as of the date the condemning authority takes such possession or title. If Tenant so elects to terminate this Lease, Base Rent and Additional Rent shall be prorated as of the date of termination. Condemnation awards and/or payments shall be the property of 31 Landlord, whether such award shall be made as compensation for diminution in value of the leasehold, the value of the part taken, or for severance damages; provided, however, that Tenant shall be entitled to compensation through a separate award from the condemning authority for (i) Tenant's relocation expenses, (ii) Tenant's loss of business goodwill, (iii) damages resulting from the cessation or interruption of Tenant's business, (iv) Tenant's personal property and/or Trade Fixtures, but not the Platform Improvements, and (v) 50% of the "bonus value" of Tenant's leasehold interest in this Lease actually awarded by the condemning authority. All Alterations made to the Premises by Tenant after the Commencement Date at Tenant's own expense (without any contribution from Landlord by means of an improvement allowance or otherwise), for purposes of Condemnation only, shall be considered the property of the Tenant and Tenant shall be entitled to any and all compensation which is payable therefor. 14.2 No Termination. In the event that this Lease is not terminated pursuant to Paragraph 14.1, Landlord shall, with reasonable diligence, proceed to restore (to the extent permitted by all Applicable Requirements and covenants, conditions and restrictions then applicable to the Premises) the Improvements to a complete functioning unit of substantially the same proportionate usefulness, design and construction existing immediately prior to the date of the Condemnation. In such case, Base Rent and Additional Rent under this Lease shall be proportionately based upon the nature of the space taken (Building space, storage, parking area) and upon the proportion which the portion taken bears to the area of the Premises immediately prior to such Condemnation. 14.3 Waiver of Statutory Provisions. Landlord and Tenant agree that the provisions of this Paragraph 14 and the remaining provisions of this Lease shall exclusively govern the rights and obligations of the parties with respect to any Condemnation of any portion of the Premises, and each of them hereby waives any statutory or common law rights or provisions inconsistent herewith. 15. Broker. (a) Tenant and Landlord each represent and warrant to the other that it has had no dealings with any person, firm, broker or finder (other than the Broker) in connection with this Lease, and that no one other than said named Broker is entitled to any commission or finder's fee in connection herewith. Tenant and Landlord do each hereby agree to indemnify, protect, defend and hold the other harmless from and against liability for compensation or charges which may be claimed by any such unnamed broker, finder or other similar party by reason of any dealings or actions of the indemnifying Party, including any costs, expenses and attorneys' fees reasonably incurred with respect thereto. The foregoing indemnification shall survive the termination or expiration of this Lease. (b) Subject to the terms and conditions of that certain Commission Agreement dated March ___, 2002 by and between __________________ _________ and The Staubach Company, in the event either or both Options to Extend (defined below) is properly exercised by Tenant in accordance with Paragraph 47, as to each such exercise of the Option to Extend, Landlord shall pay to Tenant's Broker, a brokerage commission equal to three and one-third (3-1/3%) of the Base Rent payable by Tenant with respect to the Option Term in question, one-half of which shall be payable on such proper exercise and one-half of which shall be payable upon actual commencement of the Option Term in question. The obligations of Landlord set forth in this Paragraph 15(b) shall be enforceable against the Landlord as provided in this Paragraph 15(b) by Tenant's Broker as an intended third party beneficiary, and in the event of any dispute between Landlord and Tenant's Broker with respect thereto, the nonprevailing party shall pay to the prevailing party its attorneys' fees (in accordance with Paragraph 31) (as if Tenant's Broker were a Party hereto). 16. Estoppel Certificates: (a) Each Party (as "Responding Party") shall within twenty (20) days after written notice from the other Party (the "Requesting Party") execute, acknowledge and deliver (on the basis of the Responding Party's actual knowledge, without inquiry or investigation), to the Requesting Party a statement in writing (the "Estoppel Certificate") in form similar to Exhibit "F" attached hereto, plus such additional factual information as may be reasonably requested by the Requesting Party. 32 (b) If Landlord desires to finance, refinance, ground lease or sell the Premises, or any part thereof, Tenant shall deliver to any potential lender, ground lessor or purchaser designated by Landlord such publicly available, previously reported financial statements as may be reasonably required by such lender or purchaser, including but not limited to Tenant's financial statements for the past three (3) years provided, however, that if Tenant shall be privately held, any such financial statements shall be such financial statements as shall then be in the possession of Tenant (if then in the possession of Tenant, CPA audited statements, but, if audited statements shall not then be in the possession of Tenant, Tenant's internally prepared financial statements, as certified to the actual knowledge of Tenant's treasurer or chief financial officer). All financial statements not publicly available shall be received by Landlord and such lender, partner or purchaser in confidence and Landlord shall cause such recipients to maintain the confidentiality of the same and to use the same only for the purposes herein set forth. 17. Landlord Definition/Continuing Liability. (a) Landlord shall have the absolute right to transfer all or any portion of its interest in the Premises. Subject to the provisions of Paragraph 5.3(b) and this Paragraph 17, the term "Landlord" as used herein shall mean the owner or owners at the time in question of the fee title to the Premises and in the event of a transfer of all of Landlord's legal and beneficial title or interest in the Premises, the prior Landlord shall be relieved of any liability with respect to the obligations and/or covenants under this Lease thereafter to be performed by the Landlord. (b) Notwithstanding any provision of this Lease to the contrary, (i) the original Landlord, ORIX Otay, LLC, an Illinois limited liability company ("Original Landlord") shall at all times have personal liability (with full recourse to the assets of Original Landlord) for performance of each and all of the construction obligations of the Landlord under the Work Letter as the same may be amended from time to time (the "Construction and Development Obligations") and shall continue to be primarily liable to Tenant for the performance of each and all of the Construction and Development Obligations, notwithstanding the occurrence of any transfer of all or any portion of Original Landlord's interest in the Premises or in this Lease. 18. Severability. If any provision of this Lease shall be invalid or unenforceable, the remainder of this Lease shall not be affected but shall be enforced to the extent permitted by law. 19. Days. Unless otherwise specifically indicated to the contrary, the word "days" as used in this Lease shall mean and refer to calendar days. 20. Limitation on Liability. Subject to the provisions of Paragraph 17, the obligations of Landlord under this Lease shall not constitute personal obligations of Landlord, the individual partners or members of Landlord or its or their individual partners, members, directors, officers, managing members, officers or shareholders ("Landlord Owners") and Tenant shall look to the Premises (and all sales and refinancing proceeds and all insurance and/or condemnation proceeds relating to the Premises or this Lease) and to no other assets of Landlord (or of the Landlord Owners) for the satisfaction of any liability of Landlord with respect to this Lease. 21. Time of Essence. Time is of the essence for this Lease. If the time for performance hereunder falls on a Saturday, Sunday or a day that is recognized as a holiday in the State of California, then such time shall be deemed extended to the next day that is not a Saturday, Sunday or holiday in the State of California. 33 22. No Prior or Other Agreements. All prior understandings and agreements between the Parties are merged in this Lease, which alone fully and completely expresses the agreement of the Parties with respect to any matter mentioned herein. No agreement shall be effective to modify this Lease, in whole or in part, unless such agreement is in writing, and is signed by the Party against whom enforcement of said change or modification is sought. 23. Notices. In order to be effective, each and every notice required or permitted to be given with respect to this Lease shall be in writing and shall be delivered to the address of the intended Party as specified in Paragraph 1.9 above. Notices shall be deemed properly delivered and received (i) when and if personally delivered, (ii) the same day when and if sent by confirmed facsimile, or (iii) the day of delivery to the other Party if deposited with Federal Express, UPS, or comparable commercial overnight courier service which makes delivery tracking information available to the Parties. Notices may be delivered on behalf of the Parties by their respective attorneys. In the event of a change of address by either Party, such Party shall give written notice thereof to the other Party in accordance with the foregoing. Notwithstanding the foregoing, the requirements of this Paragraph 23 shall be subject to, to the extent applicable, Section 8.6 of the Work Letter. 24. Waivers. No waiver by Landlord or Tenant of the default or breach of any term, covenant or condition hereof by the other party, shall be deemed a waiver of any other term, covenant or condition hereof, or of any subsequent default or breach by such party of the same or of any other term, covenant or condition hereof. Landlord's consent to, or approval of, any act shall not be deemed to render unnecessary the obtaining of Landlord's consent to, or approval of, any subsequent or similar act by Tenant, or be construed as the basis of an estoppel to enforce the provision or provisions of this Lease requiring such consent. The acceptance of Rent by Landlord shall not be a waiver of any Default or Breach by Tenant. 25. Recording. Either Landlord or Tenant shall, upon request of the other, execute, acknowledge and deliver to the other a short form memorandum of this Lease, substantially in the form attached hereto as Exhibit "G," for recording purposes, but no such memorandum of lease shall be recorded until after Landlord obtains fee title to the Land. The Party requesting recordation shall be responsible for payment of any fees and transfer taxes applicable thereto. 26. No Right To Holdover. Subject to the provisions of this Paragraph 26, if Tenant holds over after the expiration or earlier termination of this Lease, without the express consent of Landlord, such tenancy shall be a tenancy at sufferance only, and shall not constitute a renewal hereof or an extension for any further term, and in such case Base Rent shall be payable (a) for the first month of any such holdover at a monthly rate equal to one hundred twenty-five percent (125%) of the Base Rent applicable during the last rental period of the Lease Term and (b) beyond the first month of any such holdover at a monthly rate equal to one hundred and fifty percent (150%) of the Base Rent applicable during the last rental period of the Lease (prorated in the case of partial months on the basis of a 30-day month), and in addition, Tenant shall pay to Landlord all direct and consequential damages sustained by Landlord by reason of such holdover, provided, however, that Tenant shall not be liable to Landlord for consequential damages sustained by Landlord during the first thirty (30) days following the expiration of this Lease. Nothing contained herein shall be construed as consent by Landlord to any holding over by Tenant and shall not constitute a waiver of or limit or exclude any of Landlord's rights or remedies under this Lease, at law or in equity. 27. Cumulative Remedies. Unless expressly provided for otherwise herein, no remedy or election hereunder shall be deemed exclusive but shall, wherever possible, be cumulative at law or in equity. 28. Construction of Agreement. In construing this Lease, all headings and titles are for the convenience of the parties only and shall not be considered a part of this Lease. Whenever required by the context, the singular shall include the plural and vice versa. This Lease shall not be construed as if prepared by one of the Parties, but rather according to its fair meaning as a whole, as if both Parties had prepared it. 34 29. Binding Effect; Choice of Law. Except as otherwise expressly provided for in this Lease, this Lease shall be binding upon, and inure to the benefit of, the Parties, their personal representatives, successors and permitted assigns and be governed by and construed in accordance with the laws of the State of California. Any litigation between the Parties hereto concerning this Lease shall be initiated in the city, county, state or federal district court, as applicable, in which the Premises are located. 30. Subordination; Attornment; Non-Disturbance. 30.1 Provided that Tenant is provided with a subordination, non-disturbance and attornment agreement in a commercially reasonable form which (i) does not modify the economic terms of this Lease (or materially modify any other provision hereof) and (ii) recognizes all of Tenant's prospective and accrued rights under this Lease with respect to (A) the Letters of Credit and any matter relating to Capital Items under this Lease and (B) any default occurring before foreclosure (or delivery of a deed in lieu of foreclosure) (collectively, "Foreclosure Transfer") of a security instrument defined below) which continues after such Foreclosure Transfer ("SNDA") duly executed by the holder of any ground leases, deeds of trust, mortgages security interests (collectively, "Security Instruments") affecting the Premises, this Lease is and shall be subject and subordinate at all times to the security interests evidenced by the Security Instruments. Notwithstanding any provision of this Lease to the contrary, (a) Landlord shall not permit any Security Instrument to be recorded against the Premises or otherwise become prior to the lien of this Lease (without providing to Tenant an SNDA) prior to the earlier of the time of recordation of the Memorandum of this Lease described in Paragraph 25 (provided Tenant causes such Memorandum to be executed in recordable form, by Tenant within ten (10) business days after Landlord's request if such Memorandum was not previously recorded) or the date of Tenant's occupancy of the Premises for the conduct of business, and (b) in the event Landlord shall breach its obligations under clause (a), and Landlord shall not cure such breach (by causing such Security Instrument to be subordinate to this Lease or by providing Tenant an SNDA conforming to the requirements of this Paragraph 30) within thirty (30) days following receipt by Landlord of written notice from Tenant of such breach, without prejudice to its other rights and remedies, Tenant shall have the right to terminate this Lease, exercisable by delivery of written notice to Landlord at any time after such breach and expiration of such thirty (30) day period. 30.2 Subject to the provisions of this Paragraph 30, upon the delivery by Landlord to Tenant of an SNDA in the form and substance required by this Paragraph 30 duly executed and acknowledged by each of the holder(s) of the security interests set forth in each future Security Instrument (and if required by the terms of the SNDA, executed and acknowledged by Landlord), this Lease shall be subject and subordinate to each such future Security Instrument hereafter in force against the Land, the Improvements and/or the Building or any part thereof, if any, and to all renewals, extensions, modifications, consolidations and replacements thereof, and to all advances made or hereafter to be made upon the security of each such Security Instrument. 30.3 Subject to the provisions of this Paragraph 30 (and the provisions of the SNDAs to be delivered hereunder), Tenant agrees to attorn to the holder(s) of the security interests set forth in the Security Instruments or any successors thereto upon any such foreclosure sale or deed in lieu thereof, if so requested to do so by such holder (provided that such attornment is consistent with the terms of the applicable SNDA). 31. Attorneys' Fees. If any Party brings an action or proceeding to enforce the terms hereof or to declare rights hereunder, the Prevailing Party (as hereafter defined) in any such proceeding, action, or appeal thereon, shall be entitled to reasonable attorneys' fees. Such fees may be awarded in the same suit or recovered in a separate suit, whether or not such action or proceeding is pursued to decision or judgment. The term, "Prevailing Party" shall include, without limitation, a Party who substantially obtains or defeats the relief sought, as the case may be, whether by compromise, settlement, judgment, or the abandonment by the other Party of its claim or defense. The attorneys' fees award shall not be computed in accordance with any court fee schedule, but shall be such as to fully reimburse all attorneys' fees reasonably incurred. 35 32. Landlord's Access; Showing Premises. Subject to the provision of this Lease, Landlord and Landlord's agents, employees, consultants and Lenders shall have the right to enter the Premises at any time, in the case of an Emergency, and otherwise at reasonable times upon prior reasonable notice for the purpose of: (i) showing the same to prospective purchasers, ground landlords or lenders, or (during the last twelve (12) months of the Lease Term to prospective tenants); (ii) making such alterations, repairs, improvements or additions to the Premises as required by this Lease; and (iii) inspecting the condition of the Premises and/or compliance by Tenant with Tenant's obligations under this Lease. Subject to the provisions of this Paragraph 32 and the provisions of this Lease, all such activities shall be without abatement of Rent or liability to Tenant; provided however, such entry by Landlord shall (i) be coordinated in advance with Tenant to minimize any disruption of Tenant's operations and any damage to Tenant's property, and (ii) be accomplished as expeditiously as reasonably possible and in a manner so as to cause as little interference to Tenant (and as little damage to the property of Tenant) as reasonably possible (provided further that Landlord shall promptly replace at Landlord's cost all property of the Tenant Parties so damaged). 33. Signs. Landlord hereby agrees that Tenant, at Tenant's sole cost and expense, shall have the right during the Lease Term to install such identification signage and/or logo signage on the walls and/or fences of the Building and/or install such monument signs (the "Signage") as Tenant may desire, provided that, in each instance, Tenant shall obtain Landlord's prior written approval therefor, which approval shall not be unreasonably withheld, conditioned or delayed. The Signage shall comply with all Applicable Requirements and shall be installed and maintained by Tenant, at Tenant's sole cost and expense, in a commercially reasonably manner. Within thirty (30) days of the expiration or earlier termination of the Lease, Tenant shall, at Tenant's sole cost and expense, cause the Signage to be removed from the Building, and the portion(s) of the Building on which the Signage was located to be restored to their condition existing prior to the installation of the Signage. If Tenant fails to so remove the Building Signage and restore the area of the portion(s) of the Building on which the Building Signage was located as provided in this Paragraph 33 within such period, then Landlord may perform such work on behalf of Tenant and all good faith costs and expenses incurred by Landlord in connection therewith shall constitute Additional Rent under this Lease and shall be paid by Tenant to Landlord within thirty (30) days of demand. Tenant's rights under this Paragraph 33 shall be freely transferable by Tenant to any assignee of this Lease or any sublessee of any portion of the Premises but such transfer shall not diminish Tenant's obligations hereunder, including the obligation to comply with all Applicable Requirements. The removal and restoration obligations of Tenant as provided in this Paragraph 33 shall survive the expiration or earlier termination of this Lease. 34. Termination; Merger. Unless specifically stated otherwise in writing by Landlord, the voluntary or other surrender of this Lease by Tenant, the mutual termination or cancellation hereof, or a termination hereof by Landlord for Breach by Tenant, shall automatically terminate any sublease or lesser estate in the Premises, except as otherwise provided herein. 35. Consents. Except as otherwise provided herein, wherever in this Lease the consent of a Party is required to an act by or for the other Party, such consent shall not be unreasonably withheld, conditioned or delayed. 36. Auctions. Tenant shall not conduct, nor permit to be conducted, recurring auctions upon the Premises without Landlord's prior written consent. Landlord shall not be obligated to exercise any standard of reasonableness in considering any request for such multiple auctions. 36 37. Quiet Possession. Subject to payment by Tenant of the Rent and performance of all of the covenants, conditions and provisions on Tenant's part to be observed and performed under this Lease, Tenant shall have quiet possession and quiet enjoyment of the Premises during the Lease Term. 38. Intentionally Deleted. 39. Intentionally Deleted. 40. Security Measures. Tenant hereby acknowledges that the rental payable to Landlord hereunder does not include the cost of guard service or other security measures, and that Landlord shall have no obligation whatsoever to provide same. 41. Reservations. Subject to the provisions of this Paragraph 41, Landlord reserves to itself the right, from time to time, to grant such easement and dedications affecting the Premises as Landlord may reasonably require; provided, however, that notwithstanding any provision of this Lease to the contrary in the event such easement or dedication shall (i) adversely affect any use by Tenant of any portion of the Premises, (ii) limit the size or dimensions of the Premises, (iii) impose any material additional cost, obligation or liability risk on Tenant or any Tenant Party, (iv) adversely affect the availability, scope, intensity or cost of any utility or other service to the Premises, such easement or dedication shall require the prior written consent of Tenant, which consent shall not be unreasonably withheld, conditioned or delayed. Notwithstanding anything to the contrary contained herein, Landlord may grant any easement or dedication to the extent necessary for construction or completion of the Improvements pursuant to the Work Letter, or to the extent required by any public utility company or otherwise as is necessary to comply with any Applicable Requirements, subject to Tenant's prior written consent which shall not be unreasonably withheld, conditioned, or delayed, but, Tenant shall not withhold or condition its consent to the extent such withholding or conditioning of consent would cause Landlord not to comply with Applicable Requirements. 42. Performance Under Protest. If at any time a dispute shall arise as to any amount or sum of money to be paid by one Party to the other under the provisions hereof, the Party against whom the obligation to pay the money is asserted shall have the right to make payment "under protest" and such payment shall not be regarded as a voluntary payment and there shall survive the right on the part of said Party to institute suit for recovery of such sum. If it shall be adjudged that there was no legal obligation on the part of said Party to pay such sum or any part thereof, said Party shall be entitled to recover such sum or so much thereof as it was not legally required to pay plus interest as otherwise required in this Lease. 43. Authority. If either Party hereto is a corporation, trust, limited liability company, partnership, or similar entity, each Party represents and warrants to the other Party that each individual executing this Lease on behalf of such Party is duly authorized to execute and deliver this Lease on such Party's behalf. 44. Offer. Preparation of this Lease by either party or their agent and submission of same to the other Party shall not be deemed an offer to lease to the other Party. This Lease is not intended to be binding until executed and delivered by all Parties hereto. 45. Amendments. This Lease may be modified only in writing, signed by the Parties in interest at the time of the modification. 46. Multiple Parties. If more than one person or entity is named herein as either Landlord or Tenant, such multiple Parties shall have joint and several responsibility to comply with the terms of this Lease. 37 47. Options to Extend Term. 47.1 Grant. Provided that this Lease is in full force and effect, Landlord hereby grants to Tenant two (2) consecutive options (each, an "Option to Extend") to extend the Original Term of this Lease for a period of five (5) years each (each, an "Option Term"). Each Option to Extend must be exercised by Tenant, if at all, only by a written exercise notice delivered by Tenant to Landlord on or before the date which is twelve (12) months, but not more than twenty-four (24) months, prior to the end of the Original Term or the end of the first Option Term, as applicable. Notwithstanding anything herein to the contrary, (a) Tenant shall not be entitled to exercise an Option to Extend pursuant to this Paragraph 47 if (i) Tenant is in Breach of its obligations under this Lease (and such Breach remains uncured) at the time Tenant exercises its option to extend by written notice thereof to Landlord or (ii) following Tenant's exercise of its Option to Extend but prior, to the first day of the applicable Option Term, Tenant is in Breach of its obligations under this Lease and (b) the Options to Extend shall be exercisable only by Tenant or a permitted assignee of Tenant's entire interest in this Lease pursuant to Paragraph 12 hereof. 47.2 Terms. If Tenant properly and timely exercises the applicable Option to Extend, the Original Term of this Lease, or first Option Term, as the case may be, shall be extended by the applicable Option Term, and all of the terms, covenants and conditions of this Lease shall remain unmodified and in full force and effect during the applicable Option Term, except that the monthly Base Rent payable by Tenant pursuant to Paragraph 1.4(a) during (i) the first thirty-six (36) months of first Option Term shall be equal to the product of (A) 1.065 and (B) the monthly Base Rent payable by Tenant during the last full Lease Month of the Original Term; (ii) the final twenty-four (24) months of the first Option Term shall be equal to the product of (A) 1.1025 and (B) the monthly Base Rent payable during the last month of the immediately preceding thirty-six (36) month period, (iii) during the first thirty-six (36) months of the second Option Term shall be equal to the product of (A) 1.065 and (B) the monthly Base Rent payable by Tenant during the last month of the first Option Term and (iv) the final twenty-four (24) months of the second Option Term shall be equal to the product of (A) 1.1025 and (B) the monthly Base Rent payable during the last month of the immediately preceding thirty-six (36) month period. Base Rent during the Option Term includes consideration from Tenant to Landlord for Landlord's obligation to pay a brokerage commission in accordance with Paragraph 15(b) of this Lease. 48. Arbitration. The provisions of this Paragraph contain the sole and exclusive method, means and procedure to resolve any and all disputes or disagreements between the Parties, (including whether any particular matter constitutes, or with the passage of time (and, if applicable, the failure of a Party hereto to cure the same) would constitute a Breach) which (A) pertain to other than the payment of Base Rent under this Lease and involve an amount less than $100,000; or (B) pertain to performance of either party under, or interpretation of the provisions of, the Work Letter or (C) at the election of Tenant only (within the time periods specified in this Paragraph 48), pertain to whether any Law Change constitutes a Capital Item under Paragraph 6.3 and/or whether a particular repair or restoration of the Improvements constitutes a "Capital Item" under Paragraph 7.3; provided that nothing contained herein shall prevent Landlord from pursuing its rights and remedies with respect to the matters described in this Clause (C) if Tenant does not so elect arbitration. Except as otherwise expressly set forth herein, all disputes identified in (A), (B), or (C) above ("Arbitration Matters") arising in connection with this Lease shall be finally settled in San Diego, California under the Rules of the American Arbitration Association ("AAA") by three (3) arbitrators appointed in accordance with said Rules. The parties hereby irrevocably waive any and all rights to the contrary and shall at all times conduct themselves in strict, full, complete and timely accordance with the provisions of this Paragraph. Any and all attempts to circumvent the provisions of this provision shall be absolutely null and void and of no force or effect whatsoever. Notwithstanding the terms of this Paragraph 48 and pursuant to the provisions of Article 23 of the AAA rules, at any time before and after a Notice of Dispute is presented, the Parties shall be free to apply to any court of competent jurisdiction for interim or conservatory measures (including temporary conservatory injunctions). The Parties acknowledge and agree that any such action by a party shall not be deemed to be a breach of such party's obligation to arbitrate all disputes under this Paragraph 48 (pertaining to an Arbitration Matter) or infringe upon the powers of any arbitration panel. As to any matter (other than matters solely involving the payment of money ("Money Matters")) submitted to arbitration hereunder to determine whether it would, with the passage of time, constitute a Breach, such 38 passage of time shall not commence to run until any such affirmative determination, so long as it is simultaneously determined by the Arbitration Panel that the challenge of such matter as a potential Breach was made in good faith. As to Money Matters submitted to arbitration to determine whether such matter would, with the passage of time, constitute a Breach, such passage of time shall not commence to run in the event that the party which is obligated to make the payment does in fact make the payment to the other party. Such payment can be made "under protest," which shall occur when such payment is accompanied by a good-faith notice stating why the Party has elected to make a payment under protest. Such protest will be deemed waived unless the subject matter identified in the protest is submitted to arbitration as set forth below. The Parties acknowledge that only those matters described in the first sentence of this Paragraph 48 above shall be submitted to arbitration and all other matters (including, without limitation, matters pertaining to Landlord's exercise of any unlawful detainer rights pursuant to California law or rights or remedies used by Landlord to gain possession of the Premises or terminate Tenant's right of possession of the Premises in accordance with this Lease and Applicable Laws; provided, however, the determination of whether there is a default of a particular obligation relating to an Arbitration Matter shall be subject to Arbitration hereunder) shall be adjudicated in the court of appropriate jurisdiction. (a) Arbitration Panel. Any arbitration called for under this Paragraph 48 shall be conducted in accordance with the following procedures (which shall govern in the event of a conflict with the AAA Rules). Within thirty (30) days after delivery of written notice ("Notice of Dispute") of the existence and nature of any dispute given by any Party to the other Party, and unless otherwise provided herein in any specific instance, the Parties shall each appoint an independent arbitrator from a list of prospective arbitrators supplied by AAA to both Parties. In the event that any Party fails to so act, such appointment and notification shall be made as quickly as possible for such Party by the AAA. Within ten (10) days after such appointment and notice, such arbitrators shall appoint a third arbitrator from a list of prospective arbitrators supplied by the AAA to both Parties (together with the first two (2) arbitrators, "Arbitration Panel") and shall deliver written notice of the identity of such arbitrator and a copy of his or her written acceptance of such appointment to each of the Parties. In the event that agreement cannot be reached on the appointment of a third arbitrator within such period, such appointment and notification shall be made, upon the application of either Party, as quickly as possible by the AAA. In the event of any subsequent vacancies or inabilities to perform among the Arbitration Panel, the arbitrator or arbitrators involved shall be replaced in accordance with the provisions of this Paragraph as if such replacement was an initial appointment to be made under this Paragraph within the time constraints set forth in this Paragraph, measured from the date of notice of such vacancy or inability, to the person or persons required to make such appointment, with all the attendant consequences of failure to act timely if such appointed person is a party hereto. (b) Duty. Consistent with the provisions of this Paragraph, the members of the Arbitration Panel shall utilize their utmost skill and shall apply themselves diligently and impartially so as to hear and decide, by majority vote, the outcome and resolution of any dispute or disagreement submitted to the Arbitration Panel as promptly as possible, but in any event on or before the expiration of thirty (30) days after the appointment of all three (3) members of the Arbitration Panel. None of the members of the Arbitration Panel shall have any liability whatsoever for any acts or omissions performed or omitted in good faith pursuant to the provisions of this Paragraph. (c) Authority. The Arbitration Panel shall (i) enforce and interpret the rights and obligations set forth in this Lease to the extent not prohibited by law, (ii) fix and establish any and all rules as it shall consider appropriate in its sole and absolute discretion to govern the proceedings before it, including any and all rules of discovery, procedure and/or evidence, and (iii) make and issue any and all orders, final or otherwise, and any and all awards, as a court of competent jurisdiction sitting at law or in equity could make and issue, and as it shall consider appropriate in its sole and absolute discretion, including the awarding of monetary damages (but shall not award consequential damages to either Party and shall not award punitive damages), the awarding of reasonable attorneys' fees and costs to the prevailing party as determined by the Arbitration Panel and the issuance of injunctive relief. If the Party against whom the award is issued complies with the award, within the time period established by the Arbitration Panel, then no Breach will be deemed to have occurred, unless the Breach pertained to Money Matters, and Tenant or Landlord failed to make such payment under protest. 39 (d) Appeal. The decision of the Arbitration Panel shall be final and binding, may be confirmed and entered by any court of competent jurisdiction at the request of any Party and may not be appealed to any court of competent jurisdiction or otherwise except upon a claim of fraud on the part of the Arbitration Panel, or on the basis of a mistake as to the applicable law. The Arbitration Panel shall retain jurisdiction over any dispute until its award has been implemented, and judgment on any such award may be entered in any court having appropriate jurisdiction. (e) Compensation. Each member of the Arbitration Panel shall be compensated for any and all services rendered under this Paragraph at a rate designated by the AAA, plus reimbursement for any and all reasonable expenses incurred and documented in connection with the rendering of such services, payable in full promptly upon conclusion of the proceedings before the Arbitration Panel. Such compensation and reimbursement shall be borne by the non-prevailing Party as determined by the Arbitration Panel in its sole and absolute discretion. 49. WAIVER OF TRIAL BY JURY. THE LANDLORD AND THE TENANT, TO THE FULLEST EXTENT THAT THEY MAY LAWFULLY DO SO, HEREBY WAIVE TRIAL BY JURY IN ANY ACTION OR PROCEEDING BROUGHT BY ANY PARTY TO THIS LEASE WITH RESPECT TO THIS LEASE, THE PREMISES, OR ANY OTHER MATTER RELATED TO THIS LEASE OR THE PREMISES. IN WITNESS WHEREOF, Landlord and Tenant have executed this Lease as of the Effective Date. LANDLORD: TENANT: ORIX OTAY, LLC, FACTORY 2-U STORES, INC., an Illinois limited liability company a Delaware corporation By: ORIX Real Estate Equities, Inc., By: /s/ Norman G. Plotkin a Delaware corporation Name Printed: Norman G. Plotkin Its:Managing Member Title: Executive Vice President By: /s/ Michael J. McCullough By: /s/ Susan M. Skrokov Named Printed: Michael J. McCullough Name Printed: Susan M. Skrokov Title: Senior Vice President Title: Corporate Secretary 40 Exhibit "A" Premises Legal Description [To be Attached] Exhibit "B" Work Letter THIS WORK LETTER ("Work Letter") is entered into as of this 8th day of March, 2002, by and ORIX OTAY, LLC, an Illinois limited liability company ("Landlord"), and FACTORY 2-U STORES, INC., a Delaware corporation ("Tenant"). R E C I T A L S : A. Landlord and Tenant have entered into that certain Single Tenant Net Lease for the Premises, and this Work Letter is attached to the Lease as Exhibit "B." The Work Letter is incorporated into the Lease by this reference. Capitalized terms not defined in this Work Letter shall have the meanings given to such terms in the Lease. B. The Parties now desire to enter into this Work Letter in accordance with the terms and conditions set forth below. SECTION 1 CONSTRUCTION DOCUMENTS 1.1 Contractor's Architect. Hill Pinckert & Associates, Inc. ("Contractor's Architect"), shall act as the Contractor's Architect with respect to the design and construction of the "Improvements" (defined in Section 1.2.1 below). Concurrently with (i) the delivery by Contractor's Architect of its Letter Agreement to Contractor in accordance with Paragraph 2.2.2 of the Lease and (ii) the delivery by Kimley-Horn & Associates ("Kimley-Horn") of its letter agreement to Contractor in accordance with Paragraph 2.2.2 of the Lease, Landlord or "Contractor" (defined in Section 3.1 below) shall assume all of Tenant's obligations to the Contractor's Architect and to Kimley-Horn with respect to preparation of the Construction Drawings (defined in Section 1.2.2 below) and performance of engineering and due diligence for the Premises in a writing satisfactory to both Landlord and Tenant as set forth in Paragraph 2.2.2 of the Lease. 1.2 Improvements. 1.2.1 Improvements Defined. As used in this Work Letter and in the Lease, the "Improvements" shall mean (a) the shell improvements for the Building (defined in Paragraph 1.2 of the Lease), (b) tenant improvements within the Building which are Landlord's obligation to construct hereunder, (c) the "Platform Improvements," which shall consist of those platform improvements (including a walk-way) necessary to facilitate Tenant's access to the materials handling system at a mezzanine level, including, without limitation, lighting and sprinkler systems attached to such platform structure, (d) off-site and on-site engineering and the work and improvements related thereto, and (e) subject to the provisions of this Work Letter, all of the elements, facilities and characteristics specified in the Improvements Specifications attached hereto as Schedule "1" (collectively, the "Baseline Specifications") all to the extent such items referenced in clauses (a) through (e) above are or will be identified on the Approved Construction Documents (defined in Section 1.2.2 below) as modified by any Changes (defined in Section 5.1 below) or Required Changes (defined in Section 1.2.5 below) hereunder. In no event shall the Improvements include any improvements or improvement work to be installed or performed by or on behalf of the Tenant (other than by or for Landlord) (the "Fixture Work") with respect to computer or specialized wiring, telephone cabling, racking and the materials handling systems and any furniture or other Tenant personal property. 1.2.2 Preparation of Approved Construction Documents. Landlord and Tenant each acknowledge that they have approved the Baseline Specifications attached hereto as Schedule "1." Contractor's Architect shall prepare the architectural drawings and specifications and Contractor shall cause the engineering plans, the specifications and construction drawings to be prepared for the Improvements (collectively, the "Construction Drawings") based upon and incorporating the Baseline Specifications attached hereto (as the same may be modified hereunder). Tenant shall be permitted, subject to coordination with Landlord and Contractor, to consult with Contractor's Architect. Landlord and Tenant hereby acknowledge and agree that the Baseline Specifications (as the same may be modified as herein provided) will be the basis to complete the Construction Drawings. The Construction Drawings proposed and prepared by Contractor and Contractor's Architect shall be submitted to Tenant for its approval in accordance with the requirements below when such Construction Drawings are 30% complete, 60% complete, 90% complete and 100% complete, as reasonably determined by Landlord. Except to the extent approved by Tenant pursuant to this Section 1.2.2, and subject to Section 1.2.1, the Construction Drawings shall be consistent with the Baseline Specifications. Tenant shall have seven (7) business days from each Landlord delivery of the Construction Drawings to advise Landlord whether or not Tenant approves such delivery of the Construction Drawings, which approval shall not be unreasonably withheld, conditioned or delayed; provided, however that Tenant may disapprove, in its reasonable discretion, any part of any such Construction Drawings delivery which is not reasonably inferable from the Baseline Specifications in connection therewith, or at any other time prior to approval of the Approved Construction Drawings, Tenant may require a change in the Construction Drawings, provided, however, that Tenant may not request any change that would result in a material change in the scope of the work identified by the Baseline Specifications attached hereto without Landlord's consent, which consent shall not be unreasonably withheld, conditioned or delayed. If Tenant requests a change in, or reasonably disapproves, any Construction Drawings, Landlord shall use reasonable efforts to respond to such change or disapproval as soon as reasonably practical. Tenant shall then have five (5) days to review and approve such changes and any subsequent changes to the Construction Drawings as revised. Tenant shall deliver a reasonable response to any reasonable request by Landlord for information pertaining to the materials handling system requesting a response on March 15, 2002 or later on not less than five (5) business days prior written notice. The final Construction Drawings for the Improvements proposed by Landlord and approved by Tenant, as provided herein, and as modified by any Change or Required Change implemented after such approval by Tenant (each as hereinafter defined) shall be referred to herein collectively as the "Approved Construction Documents." 1.2.3 Permits. Once Landlord has obtained the Approved Construction Documents (or prior thereto, if appropriate), Landlord shall cause Contractor to apply for and pursue the issuance of a building permit for, and all permits or approvals required by governmental authorities having jurisdiction over, the Improvements (collectively, the "Improvements Approvals"). 1.2.4 Completion. Subject to the terms of the Lease and this Work Letter, Landlord shall cause the Contractor to complete the construction and installation of the Improvements in accordance with the Approved Construction Documents and all Applicable Requirements (defined in Paragraph 6.3 of the Lease) in effect on the date of Substantial Completion (defined in Section 6.2 below) of the Improvements. 1.2.5 Required Changes. Notwithstanding anything to the contrary contained in this Work Letter, subject to the provisions of this Section 1.2.5, Landlord shall be entitled to make changes to the Baseline Specifications, Construction Drawings or the Approved Construction Documents, to the extent such changes ("Required Changes") (i) are necessitated by any applicable building codes and other state, federal, city or county requirements of any governmental (or quasi-governmental or administrative) code, rule, regulation, law, approval or other authority, or (ii) are in connection with off-site improvements and are required to be addressed or implemented by the Improvement Approvals (or other governmental requirements not included in the Baseline Specifications), provided, however, in each case of a Required Change, Landlord shall use commercially reasonable efforts (consistent with Landlord's obligations to comply with Applicable Requirements) to minimize the scope and the amount of additional Improvements Costs (defined in Section 2.2 below) resulting from such Required Change. Promptly following receipt of notice of each material Required Change, Landlord shall notify Tenant of the same. B-2 SECTION 2 DESIGN AND CONSTRUCtiON COSTS 2.1 Design and Construction Costs for Improvements. Subject to the terms of the Lease and this Work Letter, Landlord shall pay the entire cost of designing and constructing the Improvements in accordance with the Approved Construction Documents and all Applicable Requirements. 2.2 Improvement Costs Defined. 2.2.1 Inclusions. Subject to the provisions of Section 2.2.2 below, the term "Improvement Costs" shall mean the sum of the following (and only the following): 2.2.1.1.1 Purchase Agreement Costs. All amounts paid by Landlord as purchaser pursuant to the provisions of that certain Agreement for Purchase and Sale and Joint Escrow Instructions dated January 30, 2002 entered into between Sunroad Otay Partners, L.P., a California limited partnership ("Seller") and Tenant, as amended (as so amended, the "Purchase Agreement"), (to be assigned to Landlord by Tenant pursuant to that certain Assignment of Purchase Agreement ("Assignment of Purchase Agreement") in the form of Schedule "2" attached hereto), including, without limitation, the purchase price for the Land (and any earnest money deposits) thereunder. Notwithstanding any provision of the Lease to the contrary, neither Tenant nor Landlord shall amend the Purchase Agreement (i) in any manner which will increase such amounts payable to Seller under the Purchase Agreement, or (ii) in any other material manner, without the prior written consent of the other party hereto, which consent shall not be unreasonably withheld, conditioned or delayed. 2.2.1.1.2 Other Purchase Costs. All amounts paid by Landlord to independent third parties for title reports, survey costs, title insurance and endorsements, escrow fees and costs, closing costs, recording fees, documentary transfer taxes, due diligence investigations and reports and due diligence insurance costs relating to the acquisition of the Land by Landlord under the Purchase Agreement. 2.2.1.1.3 Entitlements Costs. All amounts paid and/or reimbursed by Landlord and/or any corporation or entity controlling, controlled by, or under common control with Landlord, (collectively, Landlord's "Affiliates") to independent third parties, including, without limitation, governmental entities, engineers and lobbyists, in connection with (or on account of) the application for, negotiation and/or pursuit of, and issuance of all governmental or utility company permits, approvals, agreements, or entitlements, including, without limitation, any exaction, fee or other payment paid with respect thereto, costs in connection with complying with all laws, ordinances, rules and regulations and the cost of any onsite or offsite improvement (or bond therefor) required and paid in connection with the development and construction of the Improvements contemplated by the Lease. 2.2.1.1.4 Improvements Design and Engineering Fees and Expenses. All fees and other payments paid to Contractor's Architect under the Contractor's Architect agreement, and all fees and expenses payable to independent third party engineers and other consultants, including, without limitation, Kimley-Horn (collectively, "Landlord's Consultants") in connection with the acquisition of the Land and the design and engineering of the Improvements, and including, without limitation, preparation of the Baseline Specifications and Drawings, the Construction Drawings, the Approved Construction Documents and in connection with any Changes or Required Changes thereto. B-3 2.2.1.1.5 Improvements Construction Contract. All amounts paid by Landlord to the Contractor including under the Construction Contract or paid directly to subcontractors, material suppliers or other applicable parties with respect to the development and construction of the Improvements, provided that to the extent such parties are not included under the Construction Contract, such parties (and the amount and purpose of the payment) shall have been previously approved by Tenant, which approval shall not be unreasonably withheld. 2.2.1.1.6 Tenant Due Diligence Cost Reimbursement. Reimbursed Costs (defined in Paragraph 2.2.4(d) of the Lease) paid to Tenant under the Lease. 2.2.1.1.7 Brokerage Commissions. The amount of commission paid by Landlord to The Staubach Company ("Tenant's Broker") for the Original Term of the Lease and for acquisition of the Land under a separate agreement between Landlord and Tenant's Broker. Notwithstanding any provision of the Lease to the contrary, any commission paid to Tenant's Broker (or any other broker) with respect to any Extension Term hereunder shall not be included within Improvement Costs. 2.2.1.1.8 Cost of Capital. Subject to the provisions of Section 6.3(c) and Section 7.2.2 of this Work Letter, a cost of capital charge ("Cost of Capital Charge") equal to (x) four and one-half percent (4.5%) per annum (the "Applicable Rate") calculated on a daily basis (and prorated in the case of partial periods, on the basis of a 360 day year) of (y) all Improvement Costs (other than Cost of Capital Charges) paid by Landlord, from the date each such Improvement Cost is so paid by Landlord until the Commencement Date; provided, however, that Cost of Capital Charges shall also include an amount equal to interest at the Applicable Rate on the total Improvement Costs paid or incurred as of the Commencement Date for the first month of the Early Occupancy Period (defined in Paragraph 4.3 of the Lease). 2.2.1.1.9 Development Fee. Landlord's development fee (the "Development Fee") in the amount of Five Hundred Thousand Dollars ($500,000.00). 2.2.1.1.10 Attorney Fees. Subject to Section 2.2.2(f) hereof, Landlord's attorneys fees and expenses incurred in connection with (i) negotiating and reviewing the Purchase Agreement and any amendments thereto, and closing the purchase of the Land thereunder, (ii) pursuing the Entitlements, (iii) negotiating contracts with Contractor's Architect, Kimley-Horn, the Contractor, Landlord's Consultants and any other third party consultants participating in the acquisition of the Land and the design and/or construction of the Improvements. 2.2.1.1.11 If and to the extent consulting with independent third party consultants is reasonably required by Landlord in connection with the Fixture Work due to special issues raised by or special features of such Fixture Work), Landlord's out-of-pocket expenses incurred in retaining such consultants for such purposes. 2.2.1.1.12 Building permits, testing and inspection fees (and other governmental or utility assessments and connection fees) relating to the Improvements. B-4 2.2.1.1.13 Any property taxes or other assessments for the Premises accruing prior to the Commencement Date (and for which Landlord is responsible to pay) and not reimbursed by the Seller under the Purchase Agreement. 2.2.1.1.14 Any costs for utilities incurred by Landlord or Contractor in connection with Tenant's access to the Premises under Section 8.6 prior to the Rent Commencement Date. 2.2.1.1.15 Title insurance premiums for the Premises and fees payable on account of any construction escrow for disbursement of proceeds for construction of the Improvements. 2.2.1.1.16 Any costs (which would be Improvement Costs if applicable to the Premises) related to the Alternate Site, if any. 2.2.1.1.17 Any costs for insurance required to be provided by Landlord under the Lease and this Work Letter prior to the Commencement Date. 2.2.1.1.18 Any Tenant Delay Costs (defined in Section 7.1 below). 2.2.1.1.19 Any reasonable costs incurred in connection with any audit of all or any portion of the Improvement Costs. 2.2.1.1.20 Subject to Section 2.2.2 hereof, all other out-of-pocket costs relating to the development of the Premises and the Improvements prior to the Rent Commencement Date which Landlord may incur, which costs shall be subject to Tenant's reasonable approval. 2.2.2 Exclusions to Improvement Costs. Notwithstanding any provision of this Work Letter to the contrary, the term "Improvement Costs" shall not include any of the following: 2.2.2.1.1 Brokerage Commissions. Except for the brokerage commissions specifically described in Section 2.2.1(g) above, any commission or fee payable to any broker or finder, including, without limitation, any of the same which relate to any permanent, construction, mezzanine, unsecured, secondary or other financing for or relating to the Premises. 2.2.2.1.2 Financing Costs. Except for the amounts specifically described in Section 2.2.1(h) above, any costs, payments, fees, interest or other expenses of any kind relating to the cost of capital or any form of financing, secured or unsecured, for the Premises, or any portion thereof, including, without limitation, any permanent, construction, acquisition, mezzanine, unsecured, secondary or other financing. 2.2.2.1.3 Internal Administration Costs. Any internal or overhead costs of Landlord (or any Affiliate thereof), including, without limitation, rent, utilities, staff compensation, office supplies and the like; provided that this Section 2.2.2(c) shall not apply to the costs described in Sections 2.2.1(h) and (i). B-5 2.2.2.1.4 Payments to Landlord and Affiliates. No payments to (that are to be retained by) Landlord and its Affiliates other than the Development Fee and Cost of Capital Charges described in Sections 2.2.1(i) and (h) above. 2.2.2.1.5 Attorneys' Fees. Any attorney fees, costs or expenses relating to (i) any financing of the Premises or (ii) negotiation of the Lease or procurement of the Letter of Credit or any other purpose not specifically identified in Section 2.2.1(j). 2.2.2.1.6 Costs Unrelated to the Property. Any cost or expense not specified in this Section 2.2.2 and not directly related to (i) the acquisition, development, design or construction of the Premises or (ii) the Lease (but excluding those costs and expenses set forth in Section 2.2.1). 2.3 Final/Actual Improvement Costs and Calculation of Base Rent. Following Landlord's completion of the Improvements pursuant to this Work Letter and Landlord's calculation of actual Base Rent, Landlord shall provide a reasonably detailed notice (together with reasonable supporting documentation) to Tenant setting forth Landlord's calculation of the First Period Monthly Base Rent payable pursuant to Paragraph 1.4(a) of the Lease (the "Base Rent Notice"). Within thirty (30) days of its receipt of such Base Rent Notice, Tenant shall, by a written notice delivered to Landlord, either agree to the Base Rent as calculated by Landlord under the Base Rent Notice, or dispute such Landlord's calculation of First Period Monthly Base Rent. Any dispute under this Section 2.3 shall be subject to binding arbitration under Paragraph 48 of the Lease. The parties acknowledge that the sum of $214,375.00 per month ("Pro Forma First Period Monthly Base Rent") is the current pro forma calculation of such First Period Monthly Base Rent, based upon the current pro forma budget for Improvement Costs. Commencing with the date (pursuant to Paragraphs 1.4(a) and 4.3 of the Lease) Tenant is required to commence the payment of Base Rent under the Lease ("Rent Commencement Date") and until the actual amount of First Period Monthly Base Rent is finalized under this Section 2.3, Tenant shall pay the Pro Forma First Period Monthly Base Rent (unless the amount of the actual First Period Monthly Base Rent shall be finalized prior to the Rent Commencement Date, in which case such amount shall be paid by Tenant as the First Period Monthly Base Rent from and after the Rent Commencement Date). In the event that (i) the actual First Period Monthly Base Rent is determined to be in excess of Pro Forma First Period Monthly Base Rent, then Tenant shall pay to Landlord the total amount of monthly excess (the excess of actual First Period Monthly Base Rent over Pro Forma First Period Monthly Base Rent) for each Lease Month for which Tenant has previously paid First Period Monthly Base Rent in accordance with the Pro Forma First Period Monthly Base Rent within thirty (30) days following final determination of the actual First Period Monthly Base Rent under this Section 2.3, or (ii) alternatively, if the final determination of First Period Monthly Base Rent under this Section 2.3 reflects that Tenant has overpaid First Period Monthly Base Rent for such prior Lease Months (based upon the Pro Forma First Period Monthly Base Rent), then Landlord shall credit against the Rent next coming due under the Lease the total amount of any such overpayment (of Pro Forma First Period Monthly Base Rent in excess of actual First Period Monthly Base Rent) (until such overpayment shall be exhausted). 2.4 Allocation of Cost Responsibility. 2.4.1 Improvements Costs Generally. All Improvements Costs (a) are utilized, pursuant to Section 2.2 above, to calculate Base Rent and (b) are not (other than through payment of Base Rent pursuant to the provisions of the Lease and other than as set forth in this Work Letter) reimbursable by Tenant to Landlord. B-6 2.4.2 Impact of the Improvements Guaranteed Maximum Amount. (a) The Improvements Guaranteed Maximum Amount (defined in Section 3.2(d) below), shall be adjusted by the following: (i) The aggregate increase or decrease, as applicable, in the Improvements Guaranteed Maximum Amount, if any, resulting from all Changes to the Baseline Specifications, the Construction Drawings or the Approved Construction Documents required either by Tenant pursuant to Section 5.1 below or resulting from any Required Change. (ii) The aggregate increase in the Improvements Guaranteed Maximum Amount (including the "General Conditions" (defined in Section 3.2(d)(iii) below), if any, payable to the Contractor under the Construction Contract to the extent resulting from "Tenant Delays" (defined in Section 7.1 below) and "Force Majeure Delays" (defined in Section 7.3 below) (to the extent consistent with Landlord's general practices with respect to comparable guaranteed maximum construction contracts). (iii) The increase or decrease, as the case may be, in the Improvements Guaranteed Maximum Amount, resulting from the increase or decrease in the actual cost of any allowance item in comparison to the allowance amount set forth in the original Construction Contract or any change orders thereunder. (iv) Building permits, testing and inspection fees relating to the Improvements. (v) The costs of implementing and utilizing overtime in the schedule for the work in order to meet the Target Substantial Completion Date (as defined in Section 6.3 below), to the extent authorized by Section 6.3. (b) The Improvements Guaranteed Maximum Amount includable within Improvements Costs pursuant to Section 2.2 above shall also be decreased by fifty percent (50%) of the "savings" (from the Improvements Guaranteed Maximum Amount under the Construction Contract) achieved under the Construction Contract as anticipated under Section 3.2 below (provided, to the extent the actual "savings" provision of the actual Construction Contract ultimately executed with the Contractor shall vary from a 50/50 split, an appropriate adjustment shall be made in the application of this clause (b)). SECTION 3 THE CONTRACTOR 3.1 Contractor. Fulmer Companies shall serve as the general contractor ("Contractor") that shall perform the construction work for the Improvements. Landlord may elect to replace, in its sole discretion, the Contractor with either Lusardi Construction Company or Oltmans Construction Company at any time, subject to the prior written approval of Tenant, which approval shall not be unreasonably withheld, conditioned or delayed. Landlord's election to replace the Contractor shall not relieve Landlord from its obligations hereunder. B-7 3.2 Construction Contract. (a) Landlord shall enter into a design/build "guaranteed maximum amount" construction contract (the "Construction Contract") with the Contractor on a basis consistent with the requirements of this Work Letter (and otherwise containing commercially reasonable provisions) for the construction and installation of the Improvements in accordance with the Approved Construction Documents and all Applicable Requirements. (b) Landlord shall use commercially reasonable efforts to include in the Construction Contract commercially reasonable provisions which (i) provide commercially reasonable incentives for the Contractor to Substantially Complete all Improvements in accordance with the requirements of this Work Letter on or before March 20, 2003 (with the period of time following commencement of construction within which the Contractor shall agree to so achieve Substantial Completion being referred to herein as the "Contract Time"); and (ii) provide commercially reasonable financial penalties (which, to the extent received by Landlord, shall reduce Improvements Costs) in the event the Improvements are not Substantially Complete within the Contract Time (and such failure is a breach of the Contractor's Contract Time obligations under the Construction Contract). Notwithstanding anything to the contrary contained herein, Tenant recognizes that following the acquisition of the Land by Landlord, Tenant's sole remedy with respect to Landlord's failure to complete the Improvements on or before the Outside Termination Date (defined in Section 6.3.2 below) shall be to terminate the Lease pursuant to Section 6.3.2 hereof. (c) During design development with respect to the Construction Drawings, Landlord shall cause the Contractor to competitively bid each major trade or component and to otherwise reasonably assist Tenant to "value engineer" the Construction Drawings (and the Improvements themselves). Tenant shall have the right to review bids obtained with respect to only those items falling within those certain trade categories that involve a cost of Fifty Thousand Dollars ($50,000.00) or more (each, a "Tenant Bid Item"). Landlord shall cause Contractor to obtain and deliver to Landlord and Tenant for their review at least two (three, in the case of Tenant Bid Items in excess of $50,000) final competitive bids (each a "Bid") from qualified subcontractors in connection with each Tenant Bid Item. Landlord shall select the lowest competitive bid in each case, except where it has a commercially reasonable purpose in selecting a higher bid which commercially reasonable purpose may include the quality and availability of materials, the reputation of the party submitting the bid, and whether or not the bid meets the applicable construction schedule and timing for the construction and completion. (d) The "Improvements Guaranteed Maximum Amount" under the Construction Contract shall be subject to the prior written approval of Tenant, which approval shall not be unreasonably withheld, conditioned or delayed. In the event Tenant shall not so approve the Improvements Guaranteed Maximum Amount, and the Parties shall not otherwise agree, the "Improvements Guaranteed Maximum Amount" shall mean with respect to the Construction Contract the sum of each of the following: (i) the total of all fixed amount subcontract bids (for all trades and components of the Improvements); (ii) the total of all allowances under the Construction Contract for the Improvements (allowances shall apply to each of the items described on Schedule "3" attached hereto and to any additional items approved by Tenant, which approval shall not be unreasonably withheld, conditioned or delayed; B-8 (iii) the Contractor's General Conditions with respect to the Improvements. The Contractor's "General Conditions" for the Improvements shall be consistent with Schedule "4" attached hereto; (iv) the Contractor's Contingency with respect to the Improvements. The Contractor's "Contingency" for the Improvements shall be $140,000; (v) the Contractor's Fees with respect to the Improvements. The Contractor's "Fees" with respect to the Improvements (including with respect to all Changes) under the Construction Contract shall be 3.75% of the total "cost of the work" under the Construction Contract; (vi) any costs for insurance required to be carried by Contractor under the Construction Contract; and (vii) amounts payable by the Contractor to Contractor's Architect, Kimley-Horn and any other consultants reasonably approved in advance by Tenant for services and reimbursable expenses. (e) Landlord shall carry and maintain (or cause the Contractor to carry and maintain under the Construction Contract) from and after the date of acquisition of the Land through the Rent Commencement Date insurance consistent with Landlord's normal practices for comparable projects; provided it may also carry earthquake insurance during construction of the Improvements. (f) Contractor (and/or the applicable subcontractor, with respect to those warranties for HVAC equipment and the roof described below) shall guarantee or warrant in the Construction Contract to Tenant and Landlord that the Improvements shall be free from any defects for a period of one (1) year from the date of Substantial Completion of the Improvements; provided, however, that the warranty with respect to the HVAC equipment shall be for at least five (5) years (following Substantial Completion) and the warranty for the roof shall be for fifteen (15) years. All such warranties or guarantees as to materials or workmanship of or with respect to the Improvements that extend beyond such one (1) year period shall be contained in the Construction Contract and shall be written such that such guarantees or warranties shall be enforceable by Landlord but in the event that Landlord terminates its efforts to enforce such guarantees or warranties pursuant to Paragraph 7.2(b) of the Lease, Landlord shall either assign or permit Tenant to enforce such guarantees or warranties. SECTION 4 TENANT INSURANCE 4.1 Tenant Insurance Requirements. 4.1.1 General Coverages. During all periods that Tenant, its contractors, subcontractors or agents enter the Premises prior to the Commencement Date, Tenant shall maintain the commercial general liability insurance required to be maintained by Tenant pursuant to Paragraph 8 of the Lease. All of Tenant's contractors, subcontractors and agents entering the Premises pursuant to Section 8.6 shall carry worker's compensation insurance covering all of their respective employees, and shall also carry commercially reasonable automobile and public liability insurance. 4.1.2 General Terms. Certificates for all insurance carried pursuant to this Section 4.1 shall be delivered to Landlord before any entry by Tenant or its contractors, subcontractors or agents onto the Premises pursuant to Section 8.6. All such policies of insurance must contain a provision that the company writing said policy shall endeavor to give Landlord thirty (30) days' prior written notice of any cancellation of such insurance. Tenant shall maintain or cause to be maintained all of the foregoing insurance coverage in force until the Commencement Date. All policies for liability insurance carried under this B-9 Section 4.1 shall insure Landlord, Landlord's Lenders, Contractor and Tenant, as their interests may appear. All such insurance, except Workers' Compensation, maintained by Tenant's Agents shall preclude subrogation claims by the insurer against anyone insured thereunder. Such insurance shall provide that it is primary insurance and that any other insurance maintained by Landlord is excess and noncontributing with the insurance required hereunder. The requirements for the foregoing insurance shall not derogate from the provisions for indemnification under the Lease. Nothing contained herein shall limit the requirements and provisions in the Lease relating to Tenant's insurance obligations. SECTION 5 TENANT changes 5.1 Changes in the Approved Construction Documents. Tenant may in good faith request reasonable changes to the Approved Construction Documents (a "Proposed Change"), and, in such event, Tenant shall provide Landlord written notice detailing with reasonable specificity the Proposed Change. In the event Tenant requests a Change, Landlord shall promptly deliver to Tenant the following: (i) the Contractor's estimate of the change in Improvements Costs resulting from such proposed Change, (ii) an estimate of the number of days of Tenant Delay Period (defined in Section 7.1 below), if any, which would result from implementation of the Change (including the delay in Substantial Completion, if any, required for Landlord to consider such Change), (iii) any Tenant Delay Costs (defined in Section 7.2.1 below) to be incurred in connection with such Change, and (iv) notice either of Landlord's (A) approval of the Proposed Change (not to be unreasonably withheld or conditioned), or (B) disapproval of the Proposed Change, in which event Landlord's notice shall specify in reasonable detail the reasons for Landlord's disapproval. Tenant shall have the right, within three (3) business days after receipt from Landlord of such information, to notify Landlord whether or not Tenant elects to make such Proposed Change; provided, however, that if Landlord has disapproved of such Proposed Change, then Tenant shall have the right to elect to make such Proposed Change only if Tenant makes revisions to the Proposed Change to eliminate the reasonable grounds specified by Landlord for disapproval of such Proposed Change. If no such election is made by Tenant within said three (3) business day period, then Tenant shall be deemed to have elected not to make the applicable Proposed Change. If Tenant desires to make the Proposed Change in question, Tenant shall deliver a written notice (the "Construction Document Change Notice") to Landlord, setting forth in detail the Proposed Change Tenant desires to make to the Approved Construction Documents and, if applicable, Tenant's approval of the costs thereof and the associated Tenant Delay Period (which Tenant Delay Period shall consist of the estimate provided to Tenant by Landlord during the approval process for such Proposed Change). Any Proposed Change that is set forth in a Construction Document Change Notice shall be deemed to be a "Change" for purposes of the Lease and this Work Letter. 5.2 Governmental Compliance. The Improvements shall comply in all respects with the following: applicable building codes and other state, federal, city or quasi-governmental laws, codes, ordinances and regulations in effect on the Commencement Date, as each may apply according to the rulings of the controlling public official, agent or other person. 5.3 Inspection by Tenant. Tenant (and Tenant's Agents) shall have the right, subject to Tenant's indemnification obligation under Section 8.6 below and upon prior reasonable notice to Landlord, to inspect, on a not-to-interfere basis, the Improvements at all reasonable times; provided, however, that Tenant's failure to inspect the Improvements shall in no event constitute a waiver of any of Tenant's rights hereunder (or under the Lease) nor shall Tenant's inspection of the Improvements constitute Tenant's approval of the same (except to the extent specifically provided in the Lease and this Work Letter). B-10 5.4 Tenant's Meetings. Commencing upon execution of the Lease, Landlord shall hold regular meetings, at a reasonable time, with the Contractor regarding the progress of the preparation of Construction Drawings, bidding and value engineering of the Improvements and the construction of the Improvements, which meetings shall be held at Tenant's office prior to commencement of construction and at the Premises after commencement of construction (or, in any event, at such other place as Landlord and Tenant may mutually agree), and Tenant shall receive reasonable prior notice of, and shall have the right to attend, all such meetings. Tenant shall be permitted to invite any necessary third party consultants as are needed for coordination of the work for the Improvements. 5.5 Completion. At the conclusion of construction of the Improvements, (i) Landlord shall cause the Contractor (A) to update the Approved Construction Documents as modified under this Work Letter as to the mechanical drawing portion thereof, and to provide field-grade mark-ups of the Approved Construction Documents to reflect all changes made to the Approved Construction Documents during the course of construction, and (B) to deliver to Tenant two (2) sets of reproducibles of such updated Approved Construction Documents, together with any permits or similar documents issued by governmental agencies in connection with the construction of the Improvements, within sixty (60) days following issuance of a certificate of occupancy for the Premises, and (ii) Landlord shall deliver to Tenant a copy of all warranties, and guaranties received by Landlord from Contractor relating to the Improvements. SECTION 6 SUBSTANTIAL COMPLETION; COMMENCEMENT DATE 6.1 Commencement Date. Subject to the provisions of Section 6.3(c) and Section 7.2.2 below, the Commencement Date shall occur on the date that Substantial Completion of the Improvements is achieved and written notice thereof is delivered to Tenant. 6.2 Definition of Substantial Completion of the Improvements. For purposes of this Work Letter, "Substantial Completion" and "Substantially Complete" and other references herein and in the Lease to substantial completion shall mean, subject to the provisions of this Section 6.2, the date upon which: (i) the completion of construction of the Improvements except for minor details of construction and decoration and minor mechanical adjustments which do not materially interfere with Tenant's use of the Premises (the "Punch List Items"); (ii) Tenant has been tendered by Landlord access to, possession of and ability to occupy the Premises (for purposes of conducting the Fixture Work); (iii) Landlord has secured confirmation of completion of the Improvements (other than Fixture Work) and delivered to Tenant a copy of a certificate of occupancy or its equivalent for the Premises; and (iv) Landlord has provided Tenant access to 636 finished parking spaces and 136 finished trailer storage spaces on the Premises. Within ten (10) days of Substantial Completion of the Improvements, Landlord shall cause the Contractor to inspect the Premises and the Improvements with a representative of Tenant and reasonably complete a list of the Punch List Items, and Landlord and Tenant shall both execute such list to indicate their approval thereof. Landlord shall cause the Contractor to promptly commence and diligently pursue to completion the correction and completion of the Punch List Items, so that the Punch List Items are completed within thirty (30) days after the completion of each such list subject to Force Majeure Delays or Tenant Delays, or as soon thereafter as is reasonably practicable, taking into account Tenant's move into the Premises. Tenant shall not be entitled to commence business occupancy of the Premises for purposes of conducting its business (as opposed to the installation of the Fixture Work and furniture) until Tenant has participated in preparation of the Punch List Items. B-11 6.3 Delay in Substantial Completion. (a) Landlord agrees to use commercially reasonable efforts to cause Substantial Completion of the Improvements to occur by the date ("Target Substantial Completion Date") of April 14, 2003, subject to extension for Force Majeure Delays, Tenant Delays, and delays due to the inability to obtain the building permit (and any other permits or approvals required to commence construction) on or before July 1, 2002. In the event that, despite such commercially reasonable efforts, Landlord determines on or after January 1, 2003 that it will be unable for any reason to cause Substantial Completion of the Improvements to occur on or before June 1, 2003, Landlord shall have the right, upon written notice to Tenant, to (i) require Contractor to reasonably hire and employ overtime construction assistance to achieve such date, the additional cost of which shall be deemed to be an Improvement Cost. Any such notice shall specify, as applicable, Landlord's estimate of the increase to Improvement Costs resulting from Contractor's overtime work and Landlord's revised Target Substantial Completion Date. (b) In addition, in the event on or after January 1, 2003 (but not later than February 15, 2003), Landlord determines in good faith, based upon completion and critical path schedules then being provided by Contractor, that the then anticipated date of Substantial Completion of the Improvements is a date later than the then effective Outside Termination Date (defined below) (which is subject to extension pursuant to Section 6.3(c) below), Landlord may propose (by delivery (not later than February 15, 2003) of written notice of such proposed date to Tenant (an "Outside Termination Date Revision Notice")) that the Outside Termination Date under Section 6.3(c) be extended to the date ("New Outside Termination Date") one (1) business day following the date that the Contractor then estimates will be the date Substantial Completion of the Improvements will be achieved (which date shall also be subject to extension pursuant to clause (i) of the last sentence of Section 6.3(c) below). Within ten (10) business days of Tenant's receipt of such Outside Termination Date Revision Notice, Tenant may elect, by delivery of written notice to Landlord, to terminate this Lease; if Tenant does not so terminate this Lease within such ten (10) business days, Tenant shall be deemed to have accepted the New Outside Termination Date (specified in the Outside Termination Date Revision Notice) as the revised Outside Termination Date. (c) Notwithstanding any provision of this Work Letter or the Lease to the contrary, (i) in the event that Landlord shall not achieve Substantial Completion on or before August 1, 2003 (which date shall be subject to extension as provided in clauses (i) and (ii) of the last sentence of this Section 6.3(c)) (the "Outside Termination Date"), Landlord shall immediately notify Tenant in writing (the "Revised Date Notice") of the date the Contractor then estimates will be the date of Substantial Completion (which estimated date is referred to as the "Revised Date") and Tenant shall have, subject to the provisions of this Section 6.3(c), as its sole and absolute remedy hereunder and under the Lease (for such failure to achieve Substantial Completion by such date), the right to terminate the Lease ("Tenant's Termination Right") by delivery of written notice of termination ("Termination Notice") to Landlord (which Termination Notice shall be effective upon receipt by Landlord of such notice provided that Substantial Completion is not achieved prior to delivery to Landlord of the Termination Notice) at any time which is following such failure to timely achieve Substantial Completion but is not later than fifteen (15) business days following receipt by Tenant of Landlord's Revised Date Notice, (ii) in the event that Tenant shall not terminate this Lease pursuant to the preceding clause (i), the Revised Date specified in the Revised Date Notice shall automatically be deemed to be the new Outside Termination Date (unless Tenant shall elect (a "2004 Election"), by delivery of written notice to Landlord within the fifteen (15) business day period described in clause (i), to require that the Commencement Date shall be not earlier than January 1, 2004, in which case the new Outside Termination Date shall be the later of such Revised Date and January 1, 2004), and in the event that Landlord shall fail to achieve Substantial Completion on or before such new Outside Termination Date, the rights and obligations of Tenant and Landlord with respect to such failure shall be the same as those applicable under this Section 6.3(c) with respect to Landlord's failure to achieve Substantial Completion on or before the earlier Outside Termination Date (before revision pursuant to clause (ii)), and (iii) the process provided in the preceding provisions of this Section 6.3(c) shall be repeated until Substantial Completion is achieved or this Lease is terminated pursuant to this Section 6.3(c) (whichever event shall first occur); provided, B-12 however, in any event, if Substantial Completion is not achieved by March 31, 2004, Tenant and, provided Landlord is not in default of its obligations under this Work Letter with respect to achievement of Substantial Completion, Landlord, shall each have the right to terminate this Lease at any time which is after March 31, 2004 and is prior to achievement of Substantial Completion by delivery of written notice to the other Party hereto. Notwithstanding any provision of this Work Letter to the contrary, in the event that there shall be a 2004 Election by Tenant hereunder, there shall be no Cost of Capital Charges included within Improvements Costs with respect to the period following the Revised Date specified in Landlord's first Revised Date Notice. The Outside Termination Date (or the New Outside Termination Date, as the case may be) shall be extended (i) one (1) day for each day of Tenant Delay Period, (ii) as provided in Section 6.3(b) and (iii) as provided in this Section 6.3(c). SECTION 7 LANDLORD DELAYS; TENANT DELAYS; TENANT DELAY COSTS 7.1 Tenant Delays. ------------- For purposes of this Work Letter, subject to the provisions of this Section 7.1, the term "Tenant Delay" shall mean: (a) Tenant's failure to timely comply with any of its obligations under this Work Letter; or (b) Tenant's failure to timely take any action expressly required under this Work Letter or to timely approve any matter expressly requiring Tenant's approval pursuant to this Work Letter; or (c) Any Change requested (and approved) by Tenant pursuant to Section 5.1 in the Approved Construction Documents; or (d) Any act or omission of Tenant, or of any person, firm or corporation employed by Tenant or any of its representatives, agents, contractors or subcontractors, occurring on or about the Premises prior to the Commencement Date. Notwithstanding anything to the contrary in this Section 7.1, in the case of any claim of a "Tenant Delay," Landlord shall give Tenant written notice of the failure or other act or omission causing the Tenant Delay in question, and no Tenant Delay shall be deemed to have occurred if Tenant cures such failure or other action within twenty-four (24) business hours of receipt of such notice. The term "Tenant Delay Period" shall mean, with respect to a particular Tenant Delay, the period (expressed in calendar days) of any actual delay in achievement of Substantial Completion of the Improvements (measured by the impact on the critical path to Substantial Completion) caused by such Tenant Delay. 7.1.2 Special Rules for Tenant Delay. Notwithstanding any provision of this Work Letter or the Lease to the contrary, in no event shall the Commencement Date be affected or deferred on account of any Tenant Delays and, except as provided in Section 7.2.2 below, in no event shall the Rent Commencement Date be affected or deferred on account of any Tenant Delays. B-13 7.2 Tenant Delay Costs. 7.2.1 Definition. "Tenant Delay Costs" shall be the following: ---------- 7.2.1.1 Improvements Changes. Any increase in the Improvements Guaranteed Maximum Amount under the Construction Contract occurring following the initial calculation of the Improvements Guaranteed Maximum Amount thereunder as the result of a Change in the Baseline Specifications, the Construction Drawings or the Approved Construction Documents requested and approved by Tenant pursuant to Section 5.1. 7.2.1.2 Tenant Delays. Any costs for rescheduling work, inspection fees or any other cost (reasonably approved by Tenant) (other than costs of capital or financing costs) incurred by Landlord in constructing the Improvements hereunder on account of a Tenant Delay. 7.2.2 Application. (a) Any Tenant Delay Costs incurred by Landlord under Section 7.2.1 (and actually paid by Landlord) shall constitute an Improvements Cost under Section 2.2 above. From and after the first sixty (60) days, in the aggregate, of Tenant Delay Period, the Applicable Rate (defined in Section 2.2 above) for the period of any additional days of Tenant Delay Period (after the first sixty days) shall be adjusted to increase from 4.5% per annum to 10.67 % per annum applicable to all Improvement Costs. (b) Notwithstanding any other provision of this Work Letter or the Lease to the contrary, in the event there are more than one hundred fifty (150) days, in the aggregate, of Tenant Delay Period, the Rent Commencement Date shall be accelerated one (1) day for each Excess Tenant Delay Day (defined below). An "Excess Tenant Delay Day" means each day of Tenant Delay Period in excess of one hundred fifty (150) days, in the aggregate, of Tenant Delay Period. For example, if the Rent Commencement Date would be May 15, 2004 (without adjustment for Tenant Delay Period) and there were one hundred ninety-five (195) days of Tenant Delay Period, the Rent Commencement Date shall be accelerated forty-five (45) days to April 1, 2004. 7.3 Force Majeure Delays. For purposes of this Work Letter, the term "Force Majeure Delay" shall mean only an actual delay in Substantial Completion, resulting from strikes, lockouts or labor disputes, shortage of fuel, inability to obtain labor or materials or reasonable substitutions therefore, fire, damage or destruction to the Project, explosion, casualty, flood, hurricane, tornado, inclement weather not reasonably foreseeable by the Contractor at the time of commencement of construction; acts of God or the public enemy, sabotage, acts of terrorism, war, invasion, insurrection, rebellion, civil unrest, riots or earthquakes, and delays in obtaining permits or other governmental approvals to the extent caused by a delay in the issuance of permits or other approvals by the applicable governmental agencies generally, and not by the specifics of the Construction Drawings or Landlord's actions in attempting to obtain such permits or approvals and other similar causes beyond the reasonable control of Landlord; provided, however, that no delay in the Substantial Completion by reason of any negligence, or default (under this Lease, the Construction Contract or any subcontract) of Contractor, any direct or indirect subcontractor or agent thereof, or of Landlord or any agent or contractor thereof shall qualify as a "Force Majeure Delay." B-14 Section 8 MISCELLANEOUS 8.1 Tenant's Representative. Tenant has designated Mike Hein as its sole representative with respect to the matters set forth in this Work Letter, who, until further notice to Landlord, shall have full authority and responsibility to act on behalf of the Tenant as required in this Work Letter. 8.2 Landlord's Representative. Landlord has designated Scott Craig as its sole representative with respect to the matters set forth in this Work Letter, who, until further notice to Tenant, shall have full authority and responsibility to act on behalf of the Landlord as required in this Work Letter. 8.3 Notwithstanding any provision Paragraph 23 of the Lease (Notices) to the contrary, notices required or permitted to be given prior to the Commencement Date under Sections 1.2.2, 3.2(c), 5.1, 5.3, 5.4 and 5.5 of this Work Letter shall be deemed to have been given if such notices arose in the context of Tenant's meetings, including pursuant to Section 5.4 of this Work Letter or were delivered to the address of the intended Party as specified below (in lieu of delivery to the addresses specified in Paragraph 1.10 of the Lease), provided, however, that notwithstanding the foregoing in no event shall this Section 8.3 apply to any notice to be given under Section 2.3 , including, without limitation, the Base Rent Notice, or to any notice to be given under Section 6.3: Tenant's Representative: Mike Hein Factory 2-U Stores, Inc. 4000 Ruffin Road San Diego, CA 92123 Phone: (858) 637-4137 Fax: (858) 637-4188 Landlord's Representative: Kurt Paritz ORIX Real Estate Equities, Inc. 100 North Riverside Plaza Suite 1400 Chicago, IL 60606 8.4 Time of the Essence of This Work Letter. Time is of the essence of this Work Letter. Unless otherwise indicated, all references herein to a "number of days" shall mean and refer to calendar days. 8.5 Tenant's Lease Default. Notwithstanding any provision to the contrary contained in the Lease, if a Breach as described in the Lease occurs at any time on or before Substantial Completion of the Improvements, then (i) in addition to all other rights and remedies granted to Landlord pursuant to the Lease, Landlord shall have the right to cause the Contractor to cease the construction of the Improvements (in which case, Tenant shall be responsible for any delay in Substantial Completion caused by such work stoppage and all liens and other costs incurred by Landlord thereby). B-15 8.6 Tenant's Access. Landlord shall permit Tenant and Tenant's agents or independent contractors to enter the Premises prior to the Commencement Date, in order that Tenant may perform the Fixture Work, subject to the terms and conditions of this Section 8.6. Tenant shall give Landlord not less than five (5) days prior written notice requesting access to the Premises, which notice shall contain and/or shall be accompanied by: (a) a description of the work to be performed by those persons and entities for whom and which such access is being required; the names, itemized by trade, of who will be present in the Premises; (b) upon the reasonable request of Landlord, copies of all contracts pertaining to the performance of the work for which such early access is being requested; (c) copies of all plans and specifications pertaining to the work for which such access is being requested; (d) upon the request of Landlord, copies of all licenses and permits required in connection with the performance of the work for which such access is being requested; and (e) certificates of insurance naming Landlord and Contractor as additional insured/loss payees as applicable in form reasonably acceptable to Landlord. All of the foregoing shall be subject to Landlord's written approval, which approval may be withheld in Landlord's reasonable discretion. Entry onto the Premises on account of such Improvements shall be subject to the condition that (i) Tenant and Tenant's agents, employees, representatives, invitees, contractors, subcontractors, workmen, mechanics and suppliers shall work in reasonable harmony and not unreasonably interfere with Landlord, Contractor and their respective agents and contractors in doing its work in, to, or on the Premises; (ii) Tenant shall maintain, in full force and effect, the insurance policy or policies required under the Lease, and shall cause the Contractor to be designated as an Additional Insured; (iii) Tenant shall pay for any utilities required solely by Tenant in connection with Tenant's early access to the Premises; and (iv) the entry under this Section 8.6 of Tenant and Tenant's agents, employees, representatives, invitees, contractors, subcontractors, workmen, mechanics and suppliers shall not interfere with or delay Substantial Completion of the Improvements or issuance of the certificate of occupancy. If at any time such entry or occupancy shall cause or threaten to cause such disharmony or interference, Landlord, in Landlord's reasonable discretion, shall have the right to withdraw and cancel (to the extent reasonably necessary to eliminate such disharmony or interference) such license upon 24 hours' prior written notice to Tenant. Tenant agrees that any such entry into and occupancy of the Premises shall be deemed to be under all of the terms, covenants, conditions and provisions of the Lease, except as to the covenant to pay Rent. Tenant further agrees that to the extent permitted by law, Landlord and its principals shall not be liable in any way for any injury or death to any person or persons, loss or damage to any of Tenant's work and installations made in the Premises or loss or damage to property placed therein prior to the Commencement Date, the same being at Tenant's sole risk, unless such occurrence is due to Landlord's or Landlord's agents' gross negligence or willful misconduct. Tenant agrees to indemnify, defend and hold harmless Landlord from and against all actions, claims, demands, costs, damages, penalties or expenses of any kind (including, without limitation, attorneys' reasonable fees), which may be brought or made against Landlord, or which Landlord may pay or incur, by reason of the Tenant's early access to the Premises pursuant to this Section 8.6. B-16 IN WITNESS WHEREOF, this Work Letter is executed as of the date first written above. LANDLORD: TENANT: ORIX OTAY, LLC FACTORY 2-U STORES, INC., an Illinois limited liability company a Delaware corporation By: ORIX Real Estate Equities, Inc., a Delaware corporation Its: Managing Member By: /s/ Norman G. Plotkin Name Printed: Norman G. Plotkin Title: Executive Vice President By: /s/ Michael J. McCullough Name Printed: Michael J. McCullough Title: Senior Vice President By: /s/ Susan M. Skrokov Name Printed: Susan M. Skrokov Title: Corporate Secretary B-17 EX-23 8 exheyconsent.txt CONSENT OF ERNST & YOUNG LLP Exhibit 23.1 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statements on Form S-8 (nos. 333-76011, 333-89267, 333-94123 and 333-40682) of Factory 2-U Stores, Inc. and in the related Prospectus of our report dated February 24, 2003, with respect to the financial statements and schedule of Factory 2-U Stores, Inc. included in this Annual Report (Form 10-K) for the year ended February 1, 2003. /s/ ERNST & YOUNG LLP San Diego, California April 29, 2003 EX-23 9 exaainfo.txt INFOR REGARDING CONSENT TO ARTHUR ANDERSEN LLP Exhibit 23.2 INFORMATION REGARDING CONSENT OF ARTHUR ANDERSEN LLP Section 11(a) of the Securities Act of 1933, as amended (the "Securities Act"), provides that if part of a registration statement at the time it becomes effective contains an untrue statement of a material fact, or omits a material fact required to be stated therein or necessary to make the statements therein not misleading, any person acquiring a security pursuant to such registration statement (unless it is proved that, at the time of such acquisition such person knew of such untruth or omission) may assert a claim against, among others, an accountant who has consented to be named as having certified any part of the registration statement or as having prepared any report for use in connection with the registration statement, with respect to the statement in such registration statement or report which purports to have been prepared or certified by the accountant. In May 2002, Factory 2-U Stores, Inc. (the "Company") appointed Ernst & Young LLP as its independent auditors following the termination of the engagement of Arthur Andersen LLP ("Andersen"). For additional information, see the Company's Current Report on Form 8-K dated May 8, 2002. Because Andersen is no longer in practice as a public accountant, the Company has been unable to obtain Andersen's written consent to the incorporation by reference into the Company's Registration Statement (No. 333-40682) on Form S-8 (the "Registration Statement") of Andersen's audit report with respect to the Company's financial statements as of February 2, 2002 and for each of the two years in the period then ended. Under these circumstances, Rule 437a under the Securities Act permits the Company to file this Annual Report on Form 10-K, which is incorporated by reference into the Registration Statement, without a written consent from Andersen. As a result, with respect to transactions in the Company's securities pursuant to the Registration Statement that occur subsequent to the date this Annual Report on Form 10-K is filed with the Securities and Exchange Commission, Andersen will not have any liability under Section 11(a) of the Securities Act for any untrue statements of a material fact, or any omissions of a material fact required to be stated herein. Accordingly, you would be unable to assert a claim against Andersen under Section 11(a) of the Securities Act. The Company believes, however, that other persons that may be liable under Section 11(a) of the Securities Act, including the Company's officers and directors, may still rely on Andersen's audit reports as being made by an expert for purposes of establishing a due diligence defense under Section 11(b) of the Securities Act. EX-99 10 exhceocert.txt SECTION 906 CERT BY THE CEO Exhibit 99.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report on Form 10-K of Factory 2-U Stores, Inc. (the "Company") for the fiscal year ended February 1, 2003, as filed with the Securities Exchange Commission on the date hereof (the "Report"), I, William R. Fields, Chief Executive Officer of the Company, certify, pursuant to and for purposes of 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material aspects, the financial condition of the Company as of the dates indicated and result of operations of the Company for the periods indicated. A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. /s/ William R. Fields William R. Fields Chief Executive Officer May 2, 2003 EX-99 11 exhcfocert.txt SECTION 906 CERT BY THE CFO Exhibit 99.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Annual Report on Form 10-K of Factory 2-U Stores, Inc. (the "Company") for the fiscal year ended February 1, 2003, as filed with the Securities Exchange Commission on the date hereof (the "Report"), I, Douglas C. Felderman, Executive Vice President and Chief Financial Officer of the Company, certify, pursuant to and for purposes of 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material aspects, the financial condition of the Company as of the dates indicated and result of operations of the Company for the periods indicated. A signed original of this written statement required by Section 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. /s/ Douglas C. Felderman Douglas C. Felderman Executive Vice President, Chief Financial Officer May 2, 2003 -----END PRIVACY-ENHANCED MESSAGE-----