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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended September 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _________ TO __________
COMMISSION FILE NUMBER: 0-4408
RESOURCE AMERICA, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 72-0654145
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
1845 WALNUT STREET 19103
SUITE 1000 Zip Code
PHILADELPHIA, PA
(Address of principal executive offices)
Registrant's telephone number, including area code: 215-546-5005
Securities registered pursuant to Section 12(b) of the Act: None
Title of each class Name of each exchange on which registered
- ------------------- -----------------------------------------
None None
Securities registered pursuant to Section 12(g) of the Act:
Common stock, par value $.01 per share
--------------------------------------
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. [ ]
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Act). Yes [X] No [ ]
The aggregate market value of the voting common equity held by non-affiliates of
the registrant, based on the closing price of such stock on the last business
day of the registrant's most recently completed second fiscal quarter March 31,
2004 was approximately $287.8 million.
The number of outstanding shares of the registrant's common stock on December 1,
2004 was 17,506,600 shares.
DOCUMENTS INCORPORATED BY REFERENCE
[None]
[THIS PAGE INTENTIONALLY LEFT BLANK]
RESOURCE AMERICA, INC. AND SUBSIDIARIES
INDEX TO ANNUAL REPORT
ON FORM 10-K
Page
PART I
Item 1: Business.................................................................. 3 - 31
Item 2: Properties................................................................ 31 - 34
Item 3: Legal Proceedings......................................................... 35
Item 4: Submission of Matters to a Vote of Security Holders....................... 35
PART II
Item 5: Market for Registrant's Common Equity and Related Stockholder Matters..... 36
Item 6: Selected Financial Data................................................... 37
Item 7: Management's Discussion and Analysis of Financial Condition and
Results of Operations.................................................. 38 - 63
Item 7A: Quantitative and Qualitative Disclosures About Market Risk................ 64 - 67
Item 8: Financial Statements and Supplementary Data............................... 68 - 126
Item 9: Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.................................................... 127
Item 9A: Controls and Procedures................................................... 127
Item 9B: Other Information......................................................... 127
PART III
Item 10: Directors and Executive Officers of the Registrant........................ 128 - 130
Item 11: Executive Compensation.................................................... 130 - 134
Item 12: Security Ownership of Certain Beneficial Owners and Management............ 135 - 136
Item 13: Certain Relationships and Related Transactions............................ 137 - 138
Item 14: Principal Accountant Fees and Services.................................... 139
PART IV
Item 15: Exhibits, Financial Statement Schedules and Reports on Form 8-K........... 140 - 141
SIGNATURES...................................................................................... 142
PART I
ITEM 1. BUSINESS
THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS REGARDING EVENTS
AND FINANCIAL TRENDS WHICH MAY AFFECT OUR FUTURE OPERATING RESULTS AND FINANCIAL
POSITION. SUCH STATEMENTS ARE SUBJECT TO RISKS AND UNCERTAINTIES THAT COULD
CAUSE OUR ACTUAL RESULTS AND FINANCIAL POSITION TO DIFFER MATERIALLY FROM THOSE
ANTICIPATED IN SUCH STATEMENTS. FOR OUR BUSINESS GENERALLY, THESE RISKS INCLUDE
THE PROBABILITY OF OUR SPIN-OFF OF OUR ENERGY OPERATIONS AND OUR PLANS AND
EXPECTATIONS FOR THE OPERATIONS THAT WE WILL RETAIN FOLLOWING THE SPIN-OFF. IN
OUR ENERGY BUSINESS, THESE RISKS INCLUDE THE NEED FOR ADDITIONAL CAPITAL AND
ABILITY TO RAISE THAT CAPITAL FROM INVESTORS IN OUR DRILLING PROGRAMS, RISKS
ASSOCIATED WITH EXPLORING, DEVELOPING AND OPERATING NATURAL GAS AND OIL WELLS,
AND FLUCTUATIONS IN THE MARKET FOR NATURAL GAS AND OIL. IN REAL ESTATE, THESE
RISKS INCLUDE RISKS OF THE MARKETABILITY OF REAL ESTATE PROGRAMS, LOAN DEFAULTS,
THE ADEQUACY OF OUR PROVISION FOR LOSSES AND THE ILLIQUIDITY OF OUR LOAN
PORTFOLIO. IN OUR EQUIPMENT LEASING AND STRUCTURED FINANCE BUSINESSES, THESE
RISKS INCLUDE THE EFFECTS OF FLUCTUATIONS IN INTEREST RATES AND THE
MARKETABILITY OF EQUIPMENT LEASING AND COLLATERALIZED DEBT OBLIGATION PROGRAMS.
FOR A MORE COMPLETE DISCUSSION OF THE RISKS AND UNCERTAINTIES TO WHICH WE ARE
SUBJECT, SEE "RISK FACTORS" IN THIS ITEM 1.
GENERAL
We are a specialized asset management company that uses industry
specific expertise to generate and administer investment opportunities for our
own account and for outside investors in the structured finance, equipment
leasing, real estate and energy sectors. As a specialized asset manager, we seek
to develop investment funds in which outside investors invest along with us and
for which we manage the assets acquired pursuant to long-term management and
operating agreements. We limit our investment funds to investment areas where we
own existing operating companies or have specific expertise. We believe this
strategy enhances our return on investment as well as that of our third-party
investors. We typically receive an interest in the investment funds in addition
to the interest resulting from our investment. We managed approximately $4.2
billion in assets at the end of fiscal 2004, as follows:
o $ 2.6 billion of structured finance assets (63%); (1)
o $ 0.2 billion of equipment leasing assets (4%); (2)
o $ 0.4 billion of real estate assets (10%); (3) and
o $ 1.0 billion of energy assets (23%). (4)
- -----------------------
(1) We value our structured finance assets as the acquisition cost of
securities acquired by CDO issuers which we co-manage that acquired trust
preferred securities of regional banks and bank holding companies and the
acquisition cost of asset-backed securities acquired by us.
(2) We value our equipment leasing assets as the sum of the book values of
equipment held by us, an equipment leasing venture and an investment
partnership which we managed as of September 30, 2004.
(3) We value our managed real estate assets as the sum of the amount of our
outstanding loan receivables, including the loans underlying the assets and
liabilities consolidated pursuant to Financial Accounting Standards Board
Interpretation 46 as revised, or FIN 46R, plus the book value of our
interests in real estate and the sum of the book values of real estate and
other assets held by real estate investment partnerships we managed as of
September 30, 2004.
3
In fiscal 2004, in order to enhance shareholder value, we determined to
reorganize our company into two independent companies, with our company
continuing its asset management business in structured finance, equipment
leasing and real estate and our subsidiary, Atlas America, Inc. (NASDAQ: ATLS),
separately continuing the energy business. We took the first step in that
process in May 2004 with an initial public offering of common stock by Atlas
America and its use of the $37.0 million of net proceeds to pay us a non-taxable
dividend. We expect to complete the spin-off in fiscal 2005 by distributing our
remaining shares in Atlas America to our stockholders. However, we have sole
discretion if and when to complete the distribution and to determine its terms,
and do not intend to complete the distribution unless we receive a ruling from
the Internal Revenue Service and/or an opinion from our tax counsel as to the
tax-free nature of the distribution to us and our stockholders for U.S. federal
income tax purposes. The Internal Revenue Service requirements for tax-free
distributions of this nature are complex and the Internal Revenue Service has
broad discretion, so there is significant uncertainty as to whether we will be
able to obtain such a ruling. Because of this uncertainty and the fact that the
timing and completion of the distribution is in our sole discretion, we cannot
assure you that the distribution will occur. Pending completion of the spin-off,
we will continue to consolidate Atlas America's assets, liabilities and
operations with ours.
Following the spin-off, our continuing operations will use the
specialized asset management platform we have developed to sponsor and manage
public and private investment funds and their assets, focusing on the following:
o structured finance, principally funds issuing collateralized debt
obligations, or CDOs, backed by two principal asset classes;
- trust preferred securities of banks, bank holding companies and
insurance companies; and
- asset-backed securities or ABS.
o leasing small and mid-ticket business-essential equipment to small
to mid-size businesses; and
o real estate, principally investment partnerships focused on the
acquisition and management of multi-family apartment complexes.
We anticipate that our revenues following the spin-off will consist
principally of fees paid to us in connection with the formation of our
investment funds (including structuring, sales, acquisition and debt placement
fees) and on-going management and administration fees for our services in
managing our sponsored funds and their assets. We also expect to invest in our
sponsored funds, receiving incentive interests as well as a share of
distributions based upon the amount of our investment.
STRUCTURED FINANCE
We have co-sponsored, structured and currently co-manage seven CDO
issuers holding approximately $2.4 billion in bank and bank holding company
trust preferred securities. We have begun to expand and diversify our operations
by developing CDOs consisting of ABS.
- -----------------------
(4) We value our managed energy assets as the sum of the PV-10 (5) values, as
of September 30, 2004, of the proved reserves owned by us and the
investment partnerships and other entities whose assets we manage, plus the
book value, as of September 30, 2004, of the total assets of Atlas Pipeline
Partners, L.P.
(5) "PV-10 value" means, in accordance with guidelines of the Securities and
Exchange Commission, or SEC, the estimated future net cash flow to be
generated from the production of proved reserves discounted to present
value using an annual discount rate of 10%. This amount is calculated net
of estimated production costs and future development costs, using prices
and costs in effect as of a specified date, without escalation and without
giving effect to non-property or non-production related expenses such as
general administrative expenses, debt service or future income tax expense,
or to depreciation, depletion and amortization.
4
We own a 50% interest in an entity that manages five collateral pools
of trust preferred CDO issuers and a 33.33% interest in another entity that
manages one collateral pool of trust preferred CDO issuers. We also own a 50%
interest in the general partners of the limited partnerships that own the equity
interest of five of the Trapeza CDO issuers (known as the Trapeza Partnerships
and Structured Finance Fund). We also have invested as a limited partner in each
of these limited partnerships.
In June 2004, we formed a wholly-owned subsidiary, Ischus Capital
Management, LLC, to pursue development of and leverage our expertise in managing
CDO issuers. Ischus focuses on selecting, managing and investing in ABS. We
expect to form additional CDO issuers in other asset classes.
We derive revenues from our CDO operations through management and
administration fees. We also receive distributions on amounts we invest in the
limited partnerships. Management fees vary by CDO issuer, but have ranged from
between 0.25% and 0.60% of the collateral securities owned by the CDO issuers.
These fees are also shared with our co-sponsors. The fees are payable monthly or
semi-annually, as long as we continue as the collateral manager of the CDO
issuer. Our interest in distributions from the CDO issuers varies with the
amount of our investment in a particular limited partnership and with the terms
of our general partnership interest. In four of the partnerships, we have
incentive distribution interests. As of September 30, 2004, our investment in
limited partnership interests in the limited partnerships that own the equity of
the CDO issuers was $8.5 million.
We acquire collateral securities for our CDO issuers principally in
transactions with the issuers of those securities. We fund the initial
acquisition of the collateral securities through a warehouse credit facility
prior to the closing of a CDO issuer's offering. After the closing, the CDO
issuer acquires these collateral securities with the proceeds it receives from
the issuance of CDOs.
As part of the structuring process, we are responsible for the
evaluation of securities proposed for inclusion in the collateral pool by
originators. We analyze the creditworthiness of identified issuers and their
securities through a credit committee made up of individuals with expertise in
the asset classes to be acquired by the CDO issuer. Because CDOs must be rated
by one or more rating agencies in order for them to be eligible for many of the
institutional investors to whom they are marketed, the credit committees apply
rating agency standards when evaluating collateral securities for inclusion in a
CDO issuer's pool and then provide us with a recommendation on whether to
include or exclude the collateral from the pool.
EQUIPMENT LEASING
We operate our equipment leasing asset management business through our
subsidiary, LEAF Financial Corporation. LEAF Financial manages all aspects of
the equipment leasing process, from the origination of leases to the
end-of-lease asset disposition. After origination, LEAF Financial typically
transfers the leases either to investment partnerships sponsored by LEAF or to
third-party programs, with LEAF continuing to manage and service the lease
assets. Some leases are retained for its own account. LEAF Financial focuses on
originating small and mid-ticket equipment leases through strategic marketing
alliances and other program relationships with equipment vendors, commercial
banks and other financial institutions. The targeted lessees are small and
medium-sized companies across a wide array of industries. The primary leasing
transaction size is under $2.0 million with an average size between $50,000 and
$100,000. The equipment leased includes a wide array of business-essential
equipment, including general office, medical practice, energy and climate
control, and industrial equipment.
5
The following table sets forth certain information related to our
lessee's businesses and the concentration of our equipment on our leases under
management as of September 30, 2004, as a percentage of our total managed
portfolio:
LESSEE BUSINESS EQUIPMENT UNDER LEASE
--------------- ---------------------
Health Services 25% Industrial Equipment 14%
Personal Services 9% Software 9%
Business Services 8% Computer Systems 8%
Automotive Dealers 5% Medical Equipment 8%
Automotive Repair 5% Lasers 5%
Professional services 4% Machine Tools 5%
Wholesale Trade 3% Dry Cleaning 4%
Other Categories 41% Other Equipment Types 47%
--- ---
100% 100%
=== ===
We have sponsored two public equipment leasing partnerships, one of
which is in the operating stage and the other of which is in the pre-offering
stage. The operating investment partnership, Lease Equity Appreciation Fund I,
commenced operations in March 2003 and completed its offering period in August
2004, having raised $17.1 million of capital from investors. LEAF Financial
manages $47.6 million in leases for LEAF Fund I at September 30, 2004. LEAF
Financial received organization expense reimbursements, sales commissions and
acquisition fees in connection with the partnership's formation and receives
subordinated management fees and a general partner's interest for managing the
partnership and its assets. The pre-offering stage investment partnership, Lease
Equity Appreciation Fund II, expects its offering period will commence in
January 2005. LEAF Financial is the general partner of both investment
partnerships.
At the time we acquired LEAF Financial in 1995, it acted as the general
partner of a series of public equipment leasing partnerships. These partnerships
began their liquidation periods at various times commencing in December 1995.
The last four of these partnerships were liquidated in March 2004.
In April 2003, LEAF Financial entered into a Purchase, Sale and
Contribution Agreement with certain subsidiaries of Merrill Lynch, or ML. In
accordance with the these, we may sell and ML will purchase up to $300.0 million
of leases originated by us. LEAF earns fees from the sale of equipment leases to
ML and for servicing the ongoing portfolio.
During the years ended September 30, 2004 and 2003, LEAF originated
$149.5 million and $49.0 million in leases, respectively. As of September 30,
2004 and 2003, LEAF managed lease portfolios of $164.8 million and $63.0
million, respectively.
REAL ESTATE
General. Our real estate operations involve:
o the sponsorship and management of real estate investment
partnerships, which is the current focus of our real estate
operations; and
o the management and resolution of a portfolio of real estate loans
and property interests that we acquired at various times between
1991 and 1999.
6
Real Estate Investment Partnerships. We have sponsored two real estate
investment partnerships since 2003 which have raised a total of $25.3 million.
These partnerships, SR Real Estate Investors, L.P. and SR Real Estate Investors
II, L.P., acquired six multi-family apartment complexes. The aggregate
investment in the properties by both programs, including debt financing, was
$92.8 million. The combined market value of real estate controlled by both
programs is $106.7 million including minority interests owned by third parties.
We received acquisition and debt placement fees from the partnerships in their
acquisition stage, and receive management fees and distributions on our general
partner interests in their operational stage. We manage both the investment
partnerships as well as the properties.
Loan and Property Interest Portfolio. In addition to our real estate
investment partnerships, we also have a portfolio of real estate loans and
property interests. Between fiscal 1991 and 1999, our real estate operations
focused on the purchase of commercial real estate loans at discounts to their
outstanding loan balances and the appraised value of their underlying
properties. As a consequence of our ownership and management and resolution of
some of these loans, we have acquired direct and indirect property interests.
Since fiscal 1999, we have focused on managing and resolving our existing
portfolio. However, we may sell, purchase or originate portfolio loans or real
property investments in the future as part of our management process or as
opportunities arise. During fiscal 2004, we reduced the number of loans in our
portfolio through the repayment of seven loans and the restructuring of two
loans. We have retained interests in the properties underlying the restructured
loans. For information concerning the composition and status of our portfolio
and real estate loans and property interests, see "- Loan Status - Portfolio
Loans," " - Loan Status - Loans Held as FIN 46 Entities' Assets" and "-
Investments in Real Estate Owned."
Loan Status - Portfolio Loans. The following table sets forth
information about loans we hold in our portfolio, excluding loans consolidated
into our financial statements as a result of the adoption of FIN 46, as of
September 30, 2004 (in thousands):
Fiscal Appraised
Year Outstanding Value of
Type of Loan Loan Property Cost of
Loan Number Property Location Acquired Receivable(1) Loan(2) Investment(3)
- ----------- -------- -------- -------- ------------- ------- -------------
035(09)(10) Office Pennsylvania 1997 $ 2,915 $ 2,900 $ 3,512
041 Multifamily Connecticut 1998 21,265 23,500 14,737
013(09)(13) Single User/
Commercial California 1994 2,454 3,290 1,751
Single User/
018 Retail California 1996 3,647 6,990 2,865
-------- -------- --------
Single User Total 6,101 10,280 4,616
-------- -------- --------
Washington,
044 (11) Office DC 1998 29,626 21,705 9,848
Office Pennsylvania 2003 1,350 - 1,350
-------- -------- --------
Other Total 30,976 21,705 11,198
-------- -------- --------
Balance as of September 30, 2004 $ 61,257 $ 58,385 $ 34,063
======== ======== ========
Net Interest in
Carried Outstanding
Third Party Net Cost of Loan
Loan Number Liens(4) Investment(5) Investment(6) Receivables(7)
- ----------- -------- ------------- ------------- --------------
035 (09)(10) $ - $ 1,762 $ 2,627 $ 2,915
041 13,351 637 8,218 7,914
013 (09)(13) 2,273 (497) 67 181
018 1,967 896 1,279 1,680
-------- -------- -------- --------
4,240 399 1,346 1,861
-------- -------- -------- --------
044 (11) - 9,848 10,525 29,626
- 1,350 1,350 1,350
-------- -------- -------- --------
- 11,198 11,875 30,976
-------- -------- -------- --------
Balance as of September 30, 2004 $ 17,591 $ 13,996 $ 24,066 $ 43,666
======== ======== ======== ========
7
Loan status - Loans Held as FIN 46 Entities' Assets. The following
table sets forth information about loans consolidated into our financial
statements as a result of the adoption of FIN 46 as of September 30, 2004 (in
thousands):
Fiscal Appraised
Year Outstanding Value of
Type of Loan Loan Property Cost of
Loan Number Property Location Acquired Receivable(1) Loan(2) Investment(3)
- ----------- -------- -------- -------- ------------- ------- -------------
005 (8) Office Pennsylvania 1993 $ 13,218 $ 1,350 $ 2,295
029 Office Pennsylvania 1997 10,681 4,075 3,289
049 (12) Office Maryland 1998 117,804 93,000 95,254
-------- -------- --------
Office Total 141,703 98,425 100,838
-------- -------- --------
Condo/ 1995 &
015/028 Multifamily North Carolina 1997 7,644 3,000 2,789
032 Multifamily New Jersey 1997 15,339 11,000 7,404
050 Multifamily Illinois 1998 58,920 26,800 20,014
-------- -------- --------
Multifamily Total 81,903 40,800 30,207
-------- -------- --------
Single
007 (9)(14) User/
Retail Minnesota 1993 6,401 2,300 1,490
Single
User/
017 (9) Retail West Virginia 1996 1,784 1,600 904
-------- -------- --------
Single User Total 8,185 3,900 2,394
-------- -------- --------
Hotel/
025 Commercial Georgia 9,343 10,173 7,278
-------- -------- --------
Balance as of September 30, 2004 $241,134 $153,298 $140,717
======== ======== ========
Net Interest in
Carried Outstanding
Third Party Net Cost of Loan
Loan Number Liens(4) Investment(5) Investment(6) Receivables(7)
- ----------- -------- ------------- ------------- --------------
005 (8) $ - $ 2,295 $ 900 $ 13,218
029 - 3,289 3,199 10,681
049 (12) 56,616 35,254 35,476 61,188
-------- -------- -------- --------
56,616 40,838 39,575 85,087
-------- -------- -------- --------
015/028 2,758 (211) 292 4,886
032 - 7,404 11,097 15,339
050 14,694 4,664 7,106 44,226
-------- -------- -------- --------
17,452 11,857 18,495 64,451
-------- -------- -------- --------
007 (9)(14)
1,607 (609) 545 4,794
017 (9) 899 (95) 618 885
-------- -------- -------- --------
2,506 (704) 1,163 5,679
-------- -------- -------- --------
025 - 6,403 7,710 9,343
-------- -------- -------- --------
Balance as of September 30, 2004 $ 76,574 $ 58,394 $ 66,943 $164,560
======== ======== ======== ========
The following table reconciles the carried cost of investment for our
FIN 46 loans at September 30, 2004 (in thousands).
Assets held for sale...................................................................... $ 102,963
Liabilities associated with assets held for sale.......................................... (65,300)
FIN 46 entities' assets, net.............................................................. 30,567
Real estate owned and classified as held for sale, net of related debt.................... (1,287)
----------
Balance at September 30, 2004 - carried cost of investment................................ $ 66,943
==========
(1) Consists of the original stated or face value of the obligation plus
interest and the amount of the senior lien interest at September 30, 2004.
(2) We generally obtain appraisals on each of the properties underlying our
portfolio loans at least once every three years.
(3) Consists of the original cost of our investment, including the amount of
any senior lien obligation to which the property remains subject, plus
subsequent advances, but excludes the proceeds to us from the sale of
senior lien interests or borrower refinancing.
(4) Represents the amount of the senior lien interests at September 30, 2004.
(5) Represents the unrecovered costs of our investment, calculated as the cash
investment made in acquiring the loan plus subsequent advances, less cash
received from the sale of a senior lien interest in, or borrower
refinancing of, the loan. Negative amounts represent our receipt of
proceeds from the sale of senior lien interests or borrower refinancing in
excess of our investment.
(6) Represents the book cost of our investment, including subsequent advances,
after accretion of discount and allocation of gains from the sale of a
senior lien interest in, or borrower refinancing of, the loan, but excludes
an allowance for possible losses of $989,000. For loans held as FIN 46
entities' assets, the carried cost represents our investment adjusted to
reflect the requirements of FIN 46.
(7) Consists of the amounts set forth in the column "Outstanding Loan
Receivable" less amounts in the column "Third Party Liens" at September 30,
2004.
8
(8) The borrower, Granite GEC (Pittsburgh), L.L.C., is a limited liability
company. Daniel G. Cohen, the son of Edward E. Cohen, our chairman, and the
brother of Jonathan Z. Cohen, our chief executive officer, owns 79% of
Odessa Real Estate Management, Inc., the assistant managing member of the
borrower.
(9) With respect to loans 7 and 17, Adam Kaufman, the president, chief
executive officer of Brandywine Construction and Management, Inc. (which
provides us with property management services and in which our chairman
holds a minority interest) is the general partner of the borrower and, with
respect to loan 29, he is the President of the sole general partner of the
borrower. With respect to loan 35, Mr. Kauffman is the sole shareholder of
the general partner of the borrower. See Note 5 of our Notes to
Consolidated Financial Statements.
(10) The borrower, New 1521 Associates, is a limited partnership formed in 1991.
The general partner, New 1521 G.P., Inc., is a corporation of which Mr.
Kauffman is the sole shareholder. E. Cohen, and his wife, Betsy Z. Cohen,
beneficially own a 49% limited partnership interest in the partnership and
Mr. Kauffman owns a 24.75% limited partnership interest.
(11) The borrower, D. Cohen, is the Class B Limited Partner of Evening Star
Associates; the loan is guaranteed by The Avenue All Stars Limited
Partnership, the Class C Limited Partner of Evening Star Associates.
(12) The borrower, Commerce Place Associates, LLC, is a limited liability
company whose manager is a corporation of which Mr. Schaeffer, is the sole
shareholder, officer and director. Messrs. E. Cohen, D. Cohen, Schaeffer
and Kauffman are equal limited partners of an entity, Brandywine Equity
Investors, L.P., that owns approximately 30% of the borrower.
(13) E. Cohen and B. Cohen beneficially own a 40% limited partnership interest
in the borrower, Pasadena Industrial Associates. Mr. Kauffman is the
general partner of the borrower.
(14) The borrower, St. Cloud Associates, is a limited partnership of which Mr.
Kauffman is the sole general partner.
Management of Loan Portfolio and FIN 46 Entities' Assets. We seek to
reduce the amount of our capital invested in portfolio loans, including five
investments treated as FIN 46 entities' assets, and to enhance our returns,
through borrower refinancing of the properties underlying our loans. At
September 30, 2004, senior lien holders on these properties, including FIN 46
assets, held outstanding obligations of $94.2 million. Pursuant to agreements
with most borrowers, we generally retain the excess of operating cash flow after
required debt service on senior lien obligations as debt service on the
outstanding balance of our loans.
After a refinancing of a senior lien interest, our retained interest
will usually be secured by a subordinate lien on the property. In some
situations, however, our retained interest may not be formally secured by a
mortgage because of conditions imposed by the senior lender. In these
situations, we may be protected by a judgment lien, an unrecorded deed-in-lieu
of foreclosure, the borrower's covenant not to further encumber the property
without our consent, a pledge of the borrower's equity or similar devices. As of
September 30, 2004, we have eight retained interests aggregating $53.3 million
and constituting 59%, by carried cost of investment, of our loan portfolio and
FIN 46 assets that are not secured by a lien on the underlying property. As of
September 30, 2004, senior lien interests with an aggregate balance of $6.0
million relating to three portfolio loans obligate us, in the event of a default
on a loan, to replace the loan with a performing loan.
Because the loans in our portfolio typically were not performing in
accordance with their original terms when we acquired them, they generally are
subject to forbearance agreements that defer foreclosure or other action so long
as the borrower meets the terms of the forbearance agreement. These terms are
generally designed to give us control over the operations and cash flow of the
underlying properties, subject to the rights of senior lien holders. We may
permit a borrower to obtain management control of a property's cash flow where
we believe that operating problems have been substantially resolved.
9
Our forbearance agreements require borrowers to retain a property
management firm acceptable to us. As a result, Brandywine Construction &
Management, Inc., a property manager affiliated with us, has assumed
responsibility for supervisory and, in many cases, day-to-day management of the
underlying properties with respect to substantially our entire loan portfolio as
of September 30, 2004. In six instances, the president of Brandywine
Construction & Management, or an entity affiliated with him, has also acted as
the general partner, president or trustee of the borrower.
The minimum payments required under a forbearance agreement are
normally materially less than the debt service payments called for by the
original terms of the loan. The difference between the minimum required payments
under the forbearance agreement and the payments called for by the original loan
terms continues to accrue. However, except for amounts we recognize as accretion
of discount, we do not recognize the accrued but unpaid amounts as revenue until
actually paid. For a discussion of how we account for accretion of discount, you
should read "Real Estate-Accounting for Discounted Loans."
At the end of a forbearance agreement, the borrower must pay the loan
in full. The borrower's ability to do so, however, will depend upon a number of
factors, including prevailing conditions of the underlying property, the state
of real estate and financial markets generally and as they pertain to the
particular property, and general economic conditions. If the borrower does not
or cannot repay the loan, we anticipate it will seek to sell the property
underlying the loan or otherwise liquidate the loan. If the borrower is
unsuccessful, we may foreclose on the underlying property. Alternatively, where
we already control all of the cash flow and other economic benefits from the
property, or where we believe that the cost of foreclosure is more than any
benefit we could obtain from foreclosure, we may continue our forbearance.
Investments in Real Estate Owned. As part of the process of resolving
our loans, we may foreclose on a property underlying a loan or accept a
deed-in-lieu of foreclosure. In addition, when we restructure a loan, we may
retain an ownership interest in the underlying property or in an entity owning
the property. We had two restructurings in fiscal 2004, three in fiscal 2003 and
one in fiscal 2002. Moreover, in fiscal 2002 we invested in three limited
partnerships which acquired properties adjacent to a property in which we had
received a 50% interest in satisfaction of another portfolio loan in June 1999.
These adjacent properties were sold in March 2004.
Accounting for Discounted Loans. We accrete the difference between our
cost basis in a portfolio loan and the sum of projected cash flows from the loan
into interest income over the estimated life of the loan using the interest
method, which results in a level rate of interest over the life of the loan. We
review projected cash flows, which include amounts realizable from the
disposition of the underlying property, on a quarterly basis. Changes to
projected cash flows reduce or increase the amounts accreted into interest
income over the remaining life of the loan.
We record our investments in real estate loans at cost, which is
discounted from the stated principal amount plus accrued interest and penalties
on the loans. We refer to the stated principal, accrued interest and penalties
as the face value of the loan. The discount from face value, as adjusted to give
effect to refinancing, totaled $19.6 million, $56.0 million and $165.2 million
at September 30, 2004, 2003 and 2002, respectively. We review the carrying value
of each of our loans quarterly to determine whether it is greater than the sum
of the future projected cash flows. Because of our knowledge of the underlying
properties, our monitoring of and influence over their respective operating
budgets and, for most properties, management of the property by our affiliate,
Brandywine Construction & Management, we believe that we can reasonably estimate
the amount and timing of our probable collections from the underlying
properties. For a discussion of our involvement with the properties underlying
our loans, see "Real Estate-Management of Loan Portfolio and FIN 46 Entities'
Assets." If we determine that the carrying value is greater, we provide an
appropriate allowance through a charge to operations. In establishing our
allowance for possible losses, we also consider the historic performance of our
loan portfolio, characteristics of the loans and their underlying properties,
industry statistics and experience regarding losses in similar loans, payment
history on specific loans as well as general economic conditions in the United
States, in the borrower's geographic area or in the borrower's or its tenants'
specific industries.
10
Allowance for Possible Losses. In determining an allowance for possible
losses related to our real estate assets, we consider general and local economic
conditions, neighborhood values, competitive overbuilding, casualty losses and
other factors which may affect the value of loans. The value of our real estate
assets may also be affected by factors such as the cost of compliance with
regulations and liability under applicable environment laws, changes in interest
rates and the availability of financing. Income from a property will be reduced
if a significant number of tenants are unable to pay rent or if available space
cannot be rented on favorable terms. In addition, we continuously monitor
collections and payments from our borrowers and maintain an allowance for
estimated losses based upon our historical experience and our knowledge of
specific borrower collection issues identified. We reduce our investment in real
estate assets by an allowance for amounts that may become unrealizable in the
future. Such allowance can be either specific to a particular loan, venture or
asset or general to all loans and assets.
ENERGY
General. Atlas America is engaged in the sponsorship of drilling
investment partnerships and the development, production and transportation of
natural gas and, to a lesser extent, oil in the western New York, eastern Ohio
and western Pennsylvania region of the Appalachian Basin and in the
transportation and sale of natural gas and natural gas liquids, or NGLs, in the
south central Oklahoma and north Texas region of the Mid-continent Basin area.
As of or during the fiscal year ended September 30, 2004:
o proved reserves net to Atlas America's interest grew to 155.8 bcfe
(1) at September 30, 2004 from 144.4 bcfe at September 30, 2003, and
the PV-10 value of these reserves grew to $320.4 million from $191.4
million. During the same period, proved reserves Atlas America
manages for its drilling investment partnerships and others grew to
209.4 bcfe from 187.8 bcfe, and the PV-10 value of these reserves
grew to $457.1 million from $273.5 million;
o as of September 30, 2004, Atlas America had an acreage position of
approximately 483,600 gross (433,200 net) acres, of which 249,800
gross (236,000 net) acres were undeveloped as compared to 431,200
gross (379,000 net) acres, of which 205,400 gross (190,500 net) were
undeveloped, at September 30, 2003;
o as of September 30, 2004, Atlas America had, either directly or
through its sponsored drilling partnerships, interests in
approximately 5,755 gross wells, including royalty and overriding
royalty interests in approximately 628 wells, as compared to
interests in approximately 5,300 gross wells, including royalty and
overriding royalty interests in over 600 wells, at September 30,
2003. Atlas America operates approximately 84% of the wells in which
it has interests;
o wells in which Atlas America had an interest produced, net to its
interest, approximately 19,900 mcf(1) of natural gas and 495
barrels, or bbls(1) of oil per day during fiscal 2004, compared to
19,100 mcf of natural gas and 438 bbls of oil per day during fiscal
2003;
o the number of wells Atlas America drilled, net to both its interest
and that of its sponsored drilling investment partnerships,
increased to 450 wells in fiscal 2004 from 282 wells in fiscal 2003.
Atlas America expects to drill approximately 650 net wells in fiscal
2005; and
- ---------------------------
(1) "mcfe," "mmcfe" and "bcfe" mean thousand cubic feet equivalent, million
cubic feet equivalent and billion cubic feet equivalent, respectively.
Natural gas volumes are converted to barrels, or "bbls," of oil equivalent
using the ratio of six thousand cubic feet, or "mcf" of natural gas to one
bbl of oil and are stated at the official temperature and pressure bases of
the area in which the reserves are located.
o as of September 30, 2004, Atlas America owned and operated,
principally through its minority-owned subsidiary, Atlas Pipeline
Partners, L.P., approximately 3,700 miles of natural gas gathering
systems, as compared to approximately 1,600 miles at September 30,
2003.
Atlas America funds its drilling activities through the sponsorship of
drilling investment partnerships. Although it have been raising capital through
drilling investment partnerships since 1968, the amount of the capital raised
through these partnerships has increased substantially since 1998. Atlas America
raised $111.9 million and $75.1 million in calendar 2004 and 2003, respectively
(historically our fund-raising cycle has been on a calendar year basis). Atlas
America acts as the general partner of its sponsored drilling investment
partnerships and receives both an interest proportionate to the amount of
capital and the value of the properties it contributes, typically 25 to 28%, and
a carried interest, typically 7%, both of which are subordinated to specified
returns to the investor partners for the first five years of distributions.
Accordingly, the amount of development activities Atlas America undertakes
depends upon its ability to obtain investor subscriptions to the partnerships.
During fiscal 2004, 2003 and 2002, Atlas America's drilling investment
partnerships invested $125.0 million, $68.6 million and $75.5 million,
respectively, in drilling and completing wells, of which it contributed $31.9
million, $15.7 million and $19.7 million, respectively.
Atlas America generally structures its drilling investment partnerships
so that, upon formation of a partnership, Atlas America contributes leaseholds
to it, enters into a drilling and well operating agreement with it and becomes
its general or managing partner. In addition to providing capital for Atlas
America's drilling activities, its drilling investment partnerships are a source
of fee-based revenue. Atlas America drills all of the partnership wells under
"cost plus" contracts for which it is paid the costs of drilling the wells plus
a fee equal to 15% of those costs. Atlas America also acts as well operator and
partnership manager, for which it receives monthly operating fees of
approximately $275 per well, approximately $187 net of our interest, and monthly
administrative fees of approximately $75 per well, approximately $51 net of our
interest.
Atlas America's business strategy for increasing its reserve base
includes acquisitions of undeveloped properties or companies with significant
amounts of undeveloped property. At September 30, 2004, Atlas America had $48.3
million available under its credit facility which could be employed to finance
such acquisitions. However, as a result of agreements with us relating to our
proposed spin-off of it, Atlas America is limited in its ability to issue voting
securities, non-voting securities or convertible debt and in making acquisitions
or entering into mergers or other business combinations that would jeopardize
the tax-free status of the distribution until such time as we complete or
terminate the spin-off.
Atlas Pipeline. We conduct our natural gas transportation operations
through Atlas Pipeline, whose common units are publicly traded (NYSE: APL). As
of September 30, 2004, Atlas Pipeline owned approximately 3,300 miles of
intrastate gathering systems located in New York, Ohio, Oklahoma, Pennsylvania
and Texas to which approximately 5,200 natural gas wells were connected. Atlas
Pipeline's gathering systems had an average daily throughput of 63.5 million
cubic feet, or mmcf, 52.7 mmcf and 49.7 mmcf of natural gas in fiscal 2004, 2003
and 2002, respectively. Atlas America also directly owns approximately 400 miles
of natural gas gathering systems in Ohio and Pennsylvania, whose throughputs are
not material.
Atlas Pipeline Partners GP, LLC, is an indirect wholly-owned subsidiary
of Atlas America and general partner of Atlas Pipeline. On a consolidated basis,
it has a 2% general partner interest in Atlas Pipeline. In addition, Atlas
Pipeline Partners GP owns 1,641,026 subordinated units of Atlas Pipeline,
constituting a 22% limited partner interest in it. Atlas Pipeline Partners GP
manages the activities of Atlas Pipeline using Atlas America personnel who act
as its officers and employees.
12
The subordinated units in Atlas Pipeline are a special class of
interest under which Atlas America's right to receive distributions is
subordinated to those of the publicly-held common units. The subordination
period is scheduled to expire on January 1, 2005 provided certain financial
tests specified in the partnership agreement are met. We expect that these tests
will be met. Upon expiration of the subordination period, Atlas America's
subordinated units will convert to an equal number of common units.
The incentive distribution rights are as follows:
o until the common units and subordinated units have received
distributions of $.10 per unit in excess of the $0.42 minimum
quarterly distribution, distributable cash is allocated, 85% to unit
holders (including to Atlas America as a subordinated unit holder)
and 15% to Atlas America as a general partner;
o after that, additional available cash is allocated 75% to unit
holders and 25% to Atlas America as a general partner until the
common units and subordinated units have received distributions of
$0.08 per unit; and
o after that, available cash is allocated 50% to unit holders and 50%
to Atlas America as a general partner.
Atlas America has agreements with Atlas Pipeline that require it to do
the following:
o pay gathering fees to Atlas Pipeline for natural gas produced by
Atlas America and its drilling investment partnerships and gathered
by the gathering systems equal to the greater of $0.35 per mcf
($0.40 per mcf in certain instances) or 16% of the gross sales price
of the natural gas transported. For the years ended September 30,
2004, 2003 and 2002, these gathering fees averaged $0.88, $0.75 and
$0.57 per mcf, respectively. The cost to Atlas America of paying
these fees is offset by the transportation fees paid to it by its
drilling investment partnerships, reimbursements and distributions
to it from Atlas Pipeline and connection costs and other expenses
paid by Atlas Pipeline;
o connect wells owned or controlled by Atlas America that are within
specified distances of Atlas Pipeline's gathering systems to those
gathering systems; and
o provide stand-by construction financing to Atlas Pipeline, at its
request, for gathering system extensions and additions, to a maximum
of $1.5 million per year, until January 2005. Atlas America has not
been required to provide any construction financing under this
agreement since Atlas Pipeline's inception.
Atlas America believes that it complies with all the requirements of
these agreements.
In April 2004 and July 2004, Atlas Pipeline completed public
offerings of 750,000 and 2,100,000 common units, respectively. The net proceeds
after underwriting discounts, commissions and costs were $25.2 million and $67.5
million, respectively.
13
Acquisition of Spectrum Field Services by Atlas Pipeline. In July 2004,
Atlas Pipeline acquired Spectrum Field Services for approximately $142.4
million, including transaction costs and taxes due as a result of the
transaction. This acquisition significantly increases Atlas Pipeline's size and
diversifies the natural gas supply basins in which it operates and the natural
gas midstream services it provides to its customers. Spectrum is a natural gas
gathering and processing company headquartered in Tulsa, Oklahoma. Spectrum's
business includes gathering natural gas from oil and gas wells and processing
this raw natural gas into merchantable natural gas, or residue gas, by
extracting NGLs and removing impurities. Spectrum's principal assets consist of
a gas processing plant in Velma, Oklahoma and approximately 1,100 miles of
active and 760 miles of inactive natural gas gathering pipelines in south
central Oklahoma and north Texas. Spectrum has approximately 600 active purchase
and gathering contracts. Of these, approximately 80% (by volume) are percentage
of proceeds, or POP, contracts. Under its POP purchasing arrangements, Spectrum
purchases natural gas at the wellhead, processes the natural gas by extracting
NGLs and removing impurities and sells the residue gas and NGLs at market-based
prices, remitting to producers a contractually determined percentage of the sale
proceeds. Unlike "keep whole" contracts, which require the processor to bear the
economic risk (called the processing margin risk) such that the aggregate
proceeds from the sale of the processed natural gas and NGLs could be less than
the amount that the processor paid for the unprocessed natural gas, POP
contracts protect the processor against processing margin risk. The remaining
20% of Spectrum's purchase and gathering contracts are fixed fee, under which
Spectrum receives a fee for gathering, compressing, treating and processing
natural gas. During fiscal 2004, Spectrum processed an average of 55.1 mmcf per
day of natural gas and produced an average of 5,917 bbls per day of NGLs. The
majority of Spectrum's natural gas supply is from relatively long-lived,
mid-continent casinghead gas production.
Atlas Pipeline financed the Spectrum acquisition, including
approximately $4.2 million of transaction costs, as follows:
o borrowing $100.0 million under the term loan portion of its $135.0
million senior secured term loan and revolving credit facility
administered by Wachovia Bank, National Association (for a
description of this credit facility, see "-Credit Facilities");
o using the $20.0 million of net proceeds received from its sale to
Atlas America and us of preferred units in Atlas Pipeline Operating
Partnership; and
o using $22.4 million of the net proceeds from its April 2004 common
unit offering.
Atlas Pipeline used a portion of the net proceeds of its July 2004
offering to repay $40.0 million of the borrowings under its credit facility and
to repurchase for $20.4 million the preferred units it issued to Atlas America
and us.
Alaska Pipeline Terminated Acquisition. In September 2003, Atlas
Pipeline entered into an agreement with SEMCO Energy, Inc. to purchase all of
the stock of Alaska Pipeline Company. In order to complete the acquisition,
Atlas Pipeline needed the approval of the Regulatory Commission of Alaska. The
Regulatory Commission initially approved the transaction, but on June 4, 2004 it
vacated its order of approval based upon a motion for clarification or
reconsideration filed by SEMCO. On July 1, 2004, SEMCO sent Atlas Pipeline a
notice purporting to terminate the transaction. Atlas Pipeline believes SEMCO
caused the delay in closing the transaction and breached its obligations under
the acquisition agreement. Atlas Pipeline is currently pursuing its remedies
under the acquisition agreement. In connection with the acquisition, subsequent
termination and current legal action, Atlas Pipeline incurred $3.0 million of
costs, which are shown as terminated acquisition costs and are included in our
energy expenses on our statement of operations. See Item 7, "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Results of Operations - Energy."
Natural Gas and Oil Properties. For information concerning Atlas
America's natural gas and oil properties, including the number of wells in which
it has a working interest, as well as reserve and acreage information, see Item
2, "Properties."
14
Production. For information concerning Atlas America's natural gas and
oil production quantities, average sales prices and average production costs,
see Item 2: "Properties."
Natural Gas Sales - Appalachian Basin. Atlas America has a natural gas
supply agreement with FirstEnergy Solutions Corp. for a 10-year term which began
on April 1, 1999. Subject to certain exceptions, FirstEnergy Solutions has a
last right of refusal to buy all of the natural gas produced and delivered by
Atlas America and its affiliates, including its drilling investment
partnerships, at certain delivery points with the facilities of:
o East Ohio Gas Company, National Fuel Gas Distribution, Columbia of
Ohio, and Peoples Natural Gas Company, which are local distribution
companies; and
o National Fuel Gas Supply, Columbia Gas Transmission Corporation,
Tennessee Gas Pipeline Company, and Texas Eastern Transmission
Company, which are interstate pipelines.
FirstEnergy Solutions is the marketing affiliate of FirstEnergy Corp.
(NYSE: FE), a large regional electric utility based in Akron, Ohio. FirstEnergy
Corp. has guaranteed the monetary obligations of FirstEnergy Solutions to a
maximum of $15.0 million through March 31, 2005, and thereafter on a monthly
basis unless terminated on 30 days notice.
A portion of Atlas America's drilling investment partnerships' natural
gas is subject to the agreement with FirstEnergy Solutions, with the following
exceptions:
o natural gas sold to Warren Consolidated, an industrial end-user and
direct delivery customer;
o natural gas that at the time of the agreement was already dedicated
for the life of the well to another buyer;
o natural gas that is produced by a company which was not an affiliate
of ours at the time of the agreement;
o natural gas sold through interconnects established subsequent to the
agreement;
o natural gas that is delivered to interstate pipelines or local
distribution companies other than those described above; and
o natural gas that is produced from well(s) operated by a third-party
or subject to an agreement under which a third-party was to arrange
for the gathering and sale of the natural gas.
Based on the most recent monthly production data available as of
November 30, 2004, Atlas America anticipates that it and its affiliates,
including its drilling investment partnerships, will sell approximately 50% of
their natural gas production under the FirstEnergy Solutions agreement. The
agreement also permits Atlas America to implement gas price hedges through
FirstEnergy Solutions, as described below under "--Natural Gas Hedging -
Appalachian Basin."
The agreement established an indexed price formula for each of the
delivery points during an initial period of one or two years, and requires the
parties to negotiate a new pricing arrangement at each delivery point for
subsequent periods. If, at the end of any applicable period, the parties cannot
agree to a new price for any delivery point, then Atlas America may solicit
offers from third-parties to buy the natural gas for that delivery point. If
FirstEnergy Solutions does not match this price, then Atlas America may sell the
natural gas to the third-party. This process is repeated at the end of each
contract period which is usually one year. Atlas America markets the remainder
of its natural gas, which is principally located in the Fayette County, PA area,
primarily to Colonial Energy, Inc. and UGI Energy Services and possibly others.
15
The pricing arrangements with FirstEnergy Solutions and the other third
parties are tied to the New York Mercantile Exchange, or NYMEX, monthly futures
contract price, which is reported daily in The Wall Street Journal. The total
price received for gas is a combination of the monthly NYMEX futures price plus
a negotiated fixed premium.
The agreement with FirstEnergy Solutions may be suspended for force
majeure, which means generally such things as an act of nature, fire, storm,
flood, and explosion, but also includes the permanent closing of the factories
of Carbide Graphite or Duferco Farrell Corporation during the term of
FirstEnergy Solutions' agreements to sell natural gas to them. If these
factories were closed, however, Atlas America believes that FirstEnergy
Solutions would be able to find alternative purchasers and would not invoke the
force majeure clause.
Atlas America expects that natural gas produced from its wells, other
than described above, will be primarily tied to the spot market price and
supplied to:
o gas marketers;
o local distribution companies;
o industrial or other end-users; and/or
o companies generating electricity.
Crude Oil Sales - Appalachian Basin. Crude oil produced from Atlas
America's wells flows directly into storage tanks where it is picked up by the
oil company, a common carrier, or pipeline companies acting for the oil company
which is purchasing the crude oil. Unlike natural gas, crude oil does not
present any transportation problem. Atlas America anticipates selling any oil
produced by its wells to regional oil refining companies at the prevailing spot
market price for Appalachian crude oil in spot sales.
Natural Gas and NGL Purchases and Sales - Spectrum. Chevron Texaco is
Spectrum's largest supplier of natural gas under a contract that has a
life-of-lease or 10-year term expiring in 2010 with a year-to-year renewal
provision. The 236 wells under Chevron Texaco's contract supply approximately 10
mmcf per day to the Spectrum system. Spectrum retains a weighted average of 47%
of the NGL revenues and a weighted average of 10% of the residue gas revenues
from sales of this gas. Spectrum's remaining natural gas contracts have varying
terms: the latest expiration date is 2008, with a few scheduled to terminate in
2005. The term of others has expired, but the producers continue to sell the
natural gas under the year-to-year renewal provisions.
In February 2004, Spectrum entered into a contract with Zinke & Trumbo
to gather and process natural gas from a new development northwest of Duncan,
Oklahoma. In March 2004, Spectrum completed a 29-mile, large-diameter
high-pressure trunkline to connect this new gas supply. The Duncan line is
currently delivering nine mmcf of natural gas per day.
Spectrum sells its NGL production to Koch Hydrocarbons at the Velma gas
plant under an agreement that is renewed monthly. Spectrum has the right to
elect (on a monthly basis) whether the NGLs are sold into the Mont Belvieu or
Conway markets. NGLs are priced at the average monthly Oil Price Information
Service price for the selected market. In addition, this agreement provides for
a fee which is based upon the Houston Ship Channel spot-gas price and fluctuates
monthly between $0.0125 and $0.015 per gallon for deliveries to Mont Belvieu.
Spectrum has a transportation and fractionation contract, also with
Koch Hydrocarbons, which expires January 2006. Condensate is collected at both
at the Velma gas plant and in the Velma gathering system and sold for Spectrum's
account to SemGroup, L.P. under an agreement with a primary term which expired
on November 30, 2004. The agreement continues on a month-to-month basis.
16
Spectrum sells natural gas to purchasers at the tailgate of the Velma
gas plant. During the year ended December 31, 2003, ONEOK Energy Marketing and
Trading accounted for 85% of Spectrum's residue natural gas sales and Tenaska
Marketing Ventures accounted for 15% of such sales. Spectrum currently sells the
majority of its residue natural gas at the average of ONEOK Gas Transmission and
Southern Star Central first-of-month indices as published in Inside FERC, with
the remainder being sold on a NYMEX basis, less a fixed basis differential.
Dismantlement, Restoration, Reclamation and Abandonment Costs. When
Atlas America determines that a well is no longer capable of producing natural
gas or oil in economic quantities, it must dismantle the well and restore and
reclaim the surrounding area before it can abandon the well. Atlas America
contracts these operations to independent service providers to whom it pays a
fee. The contractor will also salvage the equipment on the well, which Atlas
America then sells in the used equipment market. Under its drilling agreements,
Atlas America is allocated abandonment costs in proportion to its partnership
interest (generally between 27% and 35%) and is allocated between 65% and 100%
of the salvage proceeds. As a consequence, Atlas America generally receives
revenues from salvaged equipment at least equal to, and typically exceeding, its
share of the related costs. See Note 2 of the Notes to Consolidated Financial
Statements, "- Asset Retirement Obligations."
Natural Gas Hedging - Appalachian Basin. Pricing for natural gas and
oil production has been volatile and unpredictable for many years. To limit
exposure to changing natural gas prices, from time to time Atlas America used
hedges for its Appalachian Basin natural gas production. Through its hedges,
Atlas America seeks to provide a measure of stability in the volatile
environment of natural gas prices. These hedges may include purchases of
regulated NYMEX futures and options contracts and non-regulated over-the-counter
futures contracts with qualified counterparties. The futures contracts are
commitments to purchase or sell natural gas at future dates and generally cover
one-month periods for up to 24 months in the future. To assure that the
financial instruments will be used solely for hedging price risks and not for
speculative purposes, Atlas America has a committee to assure that all financial
trading is done in compliance with its hedging policies and procedures. Atlas
America does not intend to contract for positions that it cannot offset with
actual production. FirstEnergy Solutions and other third-party marketers to
which Atlas America sells gas, such as Colonial Energy, Inc. and UGI Energy
Services, also use NYMEX-based financial instruments to hedge their pricing
exposure and make price hedging opportunities available to Atlas America.
Forward Sales. Atlas America also enters into forward sales
transactions which are not deemed hedges for accounting purposes because they
require firm delivery of natural gas. Thus, Atlas America limits these
arrangements to much smaller quantities than those projected to be available at
any delivery point. The price paid by FirstEnergy Solutions, Colonial Energy,
Inc., UGI Energy Services, and any other third-party marketers for certain
volumes of natural gas sold under these sales agreements may be significantly
different from the underlying monthly spot market value.
The portion of natural gas that Atlas America engages in forward sales
and the manner in which it is sold (e.g., fixed pricing, floor and/or floor
price with a cap, which we refer to as a costless collar) changes from time to
time. As of September 30, 2004, Atlas America's overall forward sales position
for the future months ending March 2006 for its natural gas production was
approximately as follows:
o 48% was sold with a fixed price;
o 1% was sold with a floor price and/or costless collar price; and
o 51% was sold subject to market-based pricing.
17
Atlas America implemented approximately 69% of these forward sales
through FirstEnergy Solutions. For information concerning Atlas America's
natural gas hedging, see Item 7A, "Quantitative and Qualitative Disclosures
about Market Risk--Commodity Price Risk," and Note 14 of the Notes to
Consolidated Financial Statements.
Natural Gas and NGL Hedging - Spectrum. Spectrum also uses hedges to
limit its exposure to changing natural gas and NGL prices. These hedges include
floating-for-fixed swaps and collars. In a floating-for-fixed swap, Spectrum
sells future production to the counterparty at a fixed price and agrees to
purchase production from the counterparty at a price that will be established on
the date of hedge settlement by reference to a specified index price. In a
collar, Spectrum purchases a put option for specified production quantities
while simultaneously selling a call option on the same amount of production.
These hedges cover periods of up to two years from the date of the hedge. To
insure that these financial instruments will be used solely for hedging price
risks and not for speculative purposes, Spectrum has established a hedging
committee to review its hedges for compliance with its hedging policies and
procedures. In addition, Spectrum does not enter into a hedge where it cannot
offset the hedge with physical residue natural gas or NGL sales.
The portion of residue natural gas and NGLs that Spectrum hedges and
the manner in which it is hedged changes from time to time. As of September 30,
2004, Spectrum's hedging position for future months through December 31, 2006
for its residue and NGL production was approximately as follows:
o 36% was hedged under floating-for-fixed swaps;
o 8% was hedged with collars; and
o 56% was not hedged and was subject to market-based pricing.
Spectrum recognizes gains and losses from the settlement of its hedges
in revenue when it sells the associated physical residue natural gas or NGLs.
Any gain or loss realized as a result of hedging is substantially offset in the
market when Spectrum sells the physical residue natural gas or NGLs. All of
Spectrum's hedges are characterized as cash flow hedges as defined in Statement
of Financial Accounting Standards No. 133. Spectrum determines gains or losses
on open and closed hedging transactions as the difference between the hedge
price and the physical price. This mark-to-market uses daily closing NYMEX
prices when applicable and an internally generated algorithm for hedged
commodities that are not traded on a market.
Availability of Oil Field Services. Atlas America contracts for
drilling rigs and purchases goods and services necessary for the drilling and
completion of wells from a number of drillers and suppliers, none of which
supplies a significant portion of its annual needs. During fiscal 2004, Atlas
America faced no shortage of these goods and services. We cannot predict the
duration of the current supply and demand situation for drilling rigs and other
goods and services with any certainty due to numerous factors affecting the
energy industry and the demand for natural gas and oil.
Major Customers. During fiscal 2004, 2003 and 2002, gas sales to
FirstEnergy Solutions accounted for 11%, 18% and 16%, respectively, of our
energy revenues. Because Spectrum has historically sold its natural gas to two
principal customers, we expect that in fiscal 2005 they may account for over 10%
of our energy revenues.
18
Competition. The energy industry is intensely competitive in all of its
aspects. Competition arises not only from numerous domestic and foreign sources
of natural gas and oil but also from other industries that supply alternative
sources of energy. Product availability and price are the principal means of
competition in selling oil and natural gas. Competition also is intense for the
acquisition of leases considered favorable for the development of natural gas
and oil in commercial quantities. Moreover, Atlas America may encounter
competition in obtaining drilling services from third party providers. Any
competition it encounters could delay it in drilling wells for its investment
partnerships. Many of Atlas America's competitors possess greater financial and
other resources than it does which may enable them to identify and acquire
desirable properties and market their natural gas and oil production more
effectively than Atlas America does. While it is impossible for us to accurately
determine Atlas America's comparative industry position, we do not consider its
operations to be a significant factor in the industry. Moreover, Atlas America
also competes with a number of other companies that offer interests in drilling
investment partnerships. As a result, competition for investment capital to fund
drilling investment partnerships is intense.
Atlas Pipeline's Appalachian Basin operations do not encounter direct
competition in their service areas since Atlas America controls the majority of
the drillable acreage in each area. However, because its Appalachian Basin
operations principally serve wells drilled by Atlas America, Atlas Pipeline is
affected by competitive factors affecting Atlas America's ability to obtain
properties and drill wells, which affects Atlas Pipeline's ability to expand
their gathering systems and to maintain or increase the volume of natural gas
they transport and, thus, their transportation revenues. Atlas America may also
encounter competition in obtaining drilling services from third-party providers.
Any competition Atlas America encounters could delay Atlas America in drilling
wells for its sponsored partnerships, and thus delay the connection of wells to
Atlas Pipeline's gathering systems.
Atlas Pipeline's omnibus agreement with Atlas America generally
requires Atlas America to connect wells it operates to Atlas Pipeline's system.
Atlas Pipeline does not expect any direct competition in connecting wells
drilled and operated by Atlas America in the future. In addition, Atlas Pipeline
occasionally connects wells operated by third parties.
In its southern Oklahoma and north Texas service area, Spectrum
competes for the acquisition of well connections with several other
gathering/servicing operations. These operations include plants operated by Duke
Energy Field Services, ONEOK Field Services and Enogex. Spectrum believes that
the principal factors upon which competition for new well connections is based
are:
o the price received by an operator for its production after deduction
of allocable charges, principally the use of the natural gas to
operate compressors; and
o responsiveness to a well operator's needs.
If Spectrum cannot compete successfully, it may be unable to obtain new
well connections and, possibly, could lose wells already connected to its
system.
19
Markets. The availability of a ready market for natural gas and oil,
and the price obtained, depends upon numerous factors beyond Atlas America's
control, as described in "- Risk Factors - Risks Relating to Our Energy
Business." During fiscal 2004, 2003 and 2002, neither Atlas America nor Spectrum
experienced any problems in selling its natural gas and oil, although prices
have varied significantly during and after those periods.
Regulation of Production. The production of natural gas and oil is
subject to a wide range of local, state and federal statutes, rules, orders and
regulations. Federal, state and local statutes and regulations require permits
for drilling operations, drilling bonds and reports concerning operations. All
of the states in which Atlas America owns and operates properties have
regulations governing conservation matters, including provisions for the
unitization or pooling of oil and natural gas properties, the establishment of
maximum allowable rates of production from oil and natural gas wells, drilling
operations, well spacing, and plugging and abandonment of wells. The effect of
these regulations is to limit the amount of natural gas and oil that Atlas
America can produce from its wells and to limit the number of wells or the
locations at which it can drill, although it can apply for exceptions to such
regulations or to have reductions in well spacing. Moreover, each state
generally imposes a production or severance tax with respect to the production
and sale of oil, natural gas and NGLs within its jurisdiction.
The failure to comply with these rules and regulations can result in
substantial penalties. Our competitors in the oil and natural gas industry are
subject to the same regulatory requirements and restrictions that affect our
operations.
Regulation of Transportation and Sale of Natural Gas. Natural gas
pipelines generally are subject to regulation by the Federal Energy Regulatory
Commission, or FERC, under the Natural Gas Act of 1938. However, because Atlas
Pipeline performs primarily a gathering function as opposed to the
transportation of natural gas in interstate commerce, we believe that it is not
subject to regulation under the Natural Gas Act. However, Atlas Pipeline
delivers a significant portion of the natural gas it transports to interstate
pipelines subject to FERC regulation. In the past, the federal government has
regulated the prices at which natural gas could be sold. While sales by
producers of natural gas can currently be made at uncontrolled market prices,
Congress could reenact price controls in the future. Deregulation of wellhead
natural gas sales began with the enactment of the Natural Gas Policy Act. In
1989, Congress enacted the Natural Gas Wellhead Decontrol Act. The Decontrol Act
removed all Natural Gas Act and Natural Gas Policy Act price and non-price
controls affecting wellhead sales of natural gas effective January 1, 1993.
Since 1985, the FERC has endeavored to make natural gas
transportation more accessible to natural gas buyers and sellers on an open and
non-discriminatory basis. The FERC has stated that open access policies are
necessary to improve the competitive structure of the interstate natural gas
pipeline industry and to create a regulatory framework that will put natural gas
sellers into more direct contractual relations with natural gas buyers by, among
other things, unbundling the sale of natural gas from the sale of transportation
and storage services. Beginning in 1992, the FERC issued Order No. 636 and a
series of related orders to implement its open access policies. As a result of
the Order No. 636 program, the marketing and pricing of natural gas have been
significantly altered. The interstate pipelines' traditional role as wholesalers
of natural gas has been eliminated and replaced by a structure under which
pipelines provide transportation and storage service on an open access basis to
others who buy and sell natural gas. Although the FERC's orders do not directly
regulate natural gas producers, they are intended to foster increased
competition within all phases of the natural gas industry.
20
In 2000, the FERC issued Order No. 637 and subsequent orders, which
imposed a number of additional reforms designed to enhance competition in
natural gas markets. Among other things, Order No. 637 revised the FERC's
pricing policy by waiving price ceilings for short-term released capacity for a
two-year experimental period, and effected changes in FERC regulations relating
to scheduling procedures, capacity segmentation, penalties, rights of first
refusal and information reporting. Most pipelines' tariff filings to implement
the requirements of Order No. 637 have been accepted by the FERC and placed into
effect. While most major aspects of Order No. 637 have been upheld on judicial
review, certain issues such as capacity segmentation and right of first refusal
were remanded to the FERC for further action. The FERC recently issued an order
affirming Order No. 637. We cannot predict what action the FERC will take on
these matters in the future, or whether the affected parties will seek, or the
FERC's actions will survive further judicial review.
Intrastate natural gas transportation is subject to regulation by state
regulatory agencies. The basis for intrastate regulation of natural gas
transportation and the degree of regulatory oversight and scrutiny given to
intrastate natural gas pipeline rates and services varies from state to state.
Insofar as regulation by a particular state will generally affect all intrastate
natural gas shippers within the state on a comparable basis, we believe that
Atlas Pipeline will not be affected in any way that materially differs from the
effects on its competitors.
Environmental and Safety Regulation. Under the Comprehensive
Environmental Response, Compensation and Liability Act, the Toxic Substances
Control Act, the Resource Conservation and Recovery Act, the Oil Pollution Act
of 1990, the Clean Air Act, and other federal and state laws relating to the
environment, owners and operators of wells producing natural gas or oil, and
pipelines, can be liable for fines, penalties and clean-up costs for pollution
caused by the wells or the pipelines. Moreover, the owners' or operators'
liability can extend to pollution costs from situations that occurred prior to
their acquisition of the assets. Natural gas pipelines are also subject to
safety regulation under the Natural Gas Pipeline Safety Act of 1968 and the
Pipeline Safety Act of 1992 which, among other things, dictate the type of
pipeline, quality of pipeline, depth, and methods of welding and other
construction-related standards. State public utility regulators have either
adopted federal standards or promulgated their own safety requirements
consistent with the federal regulations.
We do not anticipate that Atlas America or Atlas Pipeline will be
required in the near future to expend amounts that are material in relation to
our respective revenues by reason of environmental laws and regulations, but
since these laws and regulations change frequently, we cannot predict the
ultimate cost of compliance.
CREDIT FACILITIES
Atlas America has a $75.0 million credit facility administered by
Wachovia Bank, National Association. The revolving credit facility is guaranteed
by Atlas America's subsidiaries and us as long as we continue to own more than
80% of Atlas America. Up to $10.0 million of the borrowings under the facility
may be in the form of a standby letters of credit. Borrowings under the facility
are secured by the assets of Atlas America and its subsidiaries, including the
stock of Atlas America's subsidiaries. At September 30, 2004, $25.0 million was
outstanding under this facility.
Loans under the facility bear interest at one of the following two
rates, at Atlas America's election:
o the base rate plus the applicable margin; or
o the adjusted London Interbank Offered Rate, or LIBOR, plus the
applicable margin.
21
The base rate for any day equals the higher of the federal funds rate
plus 1/2 of 1% or the Wachovia Bank prime rate. Adjusted LIBOR is LIBOR divided
by 1.00 minus the percentage prescribed by the Board of Governors of the Federal
Reserve System for determining the reserve requirement for euro currency
funding. The applicable margin is as follows:
o where utilization of the borrowing base is equal to or less than
50%, the applicable margin is 0.25% for base rate loans and 1.75%
for LIBOR loans;
o where utilization of the borrowing base is greater than 50%, but
equal to or less than 75%, the applicable margin is 0.50% for base
rate loans and 2.00% for LIBOR loans; and
o where utilization of the borrowing base is greater than 75%, the
applicable margin is 0.75% for base rate loans and 2.25% for LIBOR
loans.
At September 30, 2004, borrowings under the Wachovia credit facility
bore interest at rates ranging from 3.59% to 5.0%, with an average rate of 4.1%.
The Wachovia credit facility requires Atlas America to maintain
specified net worth and specified ratios of current assets to current
liabilities and debt to earnings before interest, taxes, depreciation, depletion
and amortization, or EBITDA, and requires us to maintain a specified interest
coverage ratio as long as we continue to own more than 80% of Atlas America. In
addition, the facility limits sales, leases or transfers of assets and the
incurrence of additional indebtedness. The facility limits the dividends payable
by Atlas America to 50% of its cumulative net income from January 1, 2004 to the
date of determination plus $5.0 million and prohibits Atlas America from
declaring or paying a dividend during an event of default under the facility or
if the dividend would cause an event of default. As of September 30, 2004, Atlas
America would be permitted to pay dividends of $13.1 million under these
restrictions. The facility terminates in March 2007, when all outstanding
borrowings must be repaid.
Concurrently with the completion of the Spectrum acquisition in July
2004, Atlas Pipeline entered into a new $135.0 million senior secured term loan
and revolving credit facility administered by Wachovia Bank that replaced its
existing $20.0 million facility. The facility originally included a $35.0
million four year revolving line of credit which could be increased by an
additional $40.0 million under certain circumstances and a $100.0 million five
year term loan. Upon the completion of its July 2004 public offering, Atlas
Pipeline repaid $40.0 million of the $100.0 million term loan it had borrowed in
order to complete the acquisition of Spectrum. In August 2004, the revolving
credit lenders under the revolving credit portion of the facility agreed to
increase the amount available under the revolving credit portion to $75.0
million. Up to $5.0 million of the facility may be used for standby letters of
credit. Borrowings under the facility will be secured by a lien on and security
interest in all of Atlas Pipeline's property and that of its subsidiaries and by
the guaranty of each of its subsidiaries. The credit facility bears interest at
one of two rates, elected at Atlas Pipeline's option:
o the base rate plus the applicable margin; or
o the adjusted LIBOR plus the applicable margin.
The base rate for any day equals the higher of the federal funds rate
plus 1/2 of 1% or the Wachovia Bank prime rate. Adjusted LIBOR is LIBOR divided
by 1.00 minus the percentage prescribed by the Board of Governors of the Federal
Reserve System for determining the reserve requirement for euro currency
funding. The applicable margin for the revolving line of credit is as follows:
o where its leverage ratio, that is, the ratio of Atlas Pipeline's
debt to earnings before income, taxes, depreciation and
amortization, or EBITDA, is less than or equal to 2.5, the
applicable margin is 1.00% for base rate loans and 2.00% for LIBOR
loans;
o where its leverage ratio is greater than 2.5 but less than or equal
to 3.0, the applicable margin is 1.25% for base rate loans and 2.25%
for LIBOR loans;
22
o where its leverage ratio is greater than 3.0 but less than or equal
to 3.5, the applicable margin is 1.75% for base rate loans and 2.75%
for LIBOR loans; and
o where its leverage ratio is greater than 3.5, the applicable margin
is 2.25% for base rate loans and 3.25% for LIBOR loans.
The applicable margin for the term loan is .75% higher for both base
rate loans and LIBOR loans.
The credit facility requires Atlas Pipeline to maintain a ratio of
funded debt to EBITDA of not more than 4.25 to 1.0, reducing to 4.0 to 1.0 on
December 31, 2004 and 3.5 to 1.0 on June 30, 2005 and an interest coverage ratio
of not less than 3.0 to 1.0. In addition, Atlas Pipeline will be required to
prepay the term loan with the net proceeds of any asset sales or issuances of
debt. With respect to any issuances of equity, it will be required to repay the
term loan from the proceeds of such issuances to the extent its ratio of funded
debt to EBITDA exceeds 3.5 to 1.0. Atlas Pipeline is required to pay down
$750,000 in principal on the outstanding balance of the term loan quarterly. Any
prepayments of principal with proceeds from asset or equity sales will be
credited pro rata against this repayment obligation.
The credit agreement contains covenants customary for loans of this
size, including restrictions on incurring additional debt and making material
acquisitions, and a prohibition on paying distributions to Atlas Pipeline's
unitholders if an event of default occurs. The events which constitute an event
of default are also customary for loans of this size, including payment
defaults, breaches of Atlas Pipeline's representations or covenants contained in
the credit agreement, adverse judgments against it in excess of a specified
amount, and a change of control of its general partner.
Through our real estate subsidiaries, we have an $18.0 million line of
credit with Sovereign Bank. The facility bears interest at the prime rate
reported in The Wall Street Journal and expires in July 2005. Advances under
this facility must be used to acquire real property, loans on real property or
to reduce indebtedness on property loans. The facility is secured by the
interest of our subsidiaries in assets they acquire using advances under the
line of credit. Credit availability is based on the value of the assets pledged
as security and was $18.0 million as of September 30, 2004, none of which had
been drawn at that date. The facility imposes limitations on the incurrence of
future indebtedness by our subsidiaries whose assets were pledged, and on sales,
transfers or leases of their assets, and requires the subsidiaries to maintain
both a specified level of equity and a specified debt service coverage ratio.
LEAF Financial entered into revolving credit facilities with National
City Bank and Commerce Bank that have an aggregate borrowing limit of $35.0
million. Each facility bears interest at LIBOR plus 300 basis points at the time
of borrowing. Borrowings under the facilities are secured by an assignment of
the leases being financed and the underlying equipment being leased. Repayment
of both facilities has been guaranteed by us. The facility with National City
Bank expires on April 30, 2005. At September 30, 2004, $8.5 million was
outstanding on this facility at interest rates ranging from 4.1% to 4.8% with an
average rate of 4.3% during fiscal 2004. The facility with Commerce Bank expires
on November 30, 2005. At September 30, 2004, $9.6 million was outstanding on
this facility at interest rates ranging from 4.1% to 4.7% with an average
interest rate of 4.4% during fiscal 2004.
EMPLOYEES
As of September 30, 2004, we employed 332 persons: 227 in energy, 64 in
equipment leasing, 14 in real estate, eight in structured finance and 19
corporate employees.
23
RISK FACTORS
General
Interest rate increases will increase our interest costs. See Item 7A,
"Quantitative and Qualitative Disclosures about Market Risk." This could have
material adverse effects on us, including reduction of net income for our
structured finance, equipment leasing, real estate and energy operations.
Our business strategy in structured finance, equipment leasing and real
estate and Atlas America's strategy in energy, depends upon our ability to
obtain capital through the sponsorship of investment funds which, in turn,
depends upon a number of factors discussed in this section and elsewhere in this
report. If we are unable to raise capital through these funds, our ability to
increase our managed assets and revenues will be limited and our profitability
may decline.
Subsidiaries of ours currently serve as general partners of two public
equipment leasing partnerships, including one in the pre-offering stage, three
private real estate investment partnerships, including one in the offering
stage, seven private investment partnerships that have invested and will invest
in CDO issuers, one of which is in the offering stage, 87 drilling investment
partnerships and Atlas Pipeline. We intend to develop further investment
partnerships for which our subsidiaries will act as general partner. As a
general partner, each subsidiary is contingently liable for the obligations of
these partnerships to the extent that their obligations cannot be repaid from
partnership assets or insurance proceeds.
Risks Relating to Our Structured Finance, Equipment Leasing and Real Estate
Operations
We account for our investment in the Trapeza CDO programs, described in
"Business-Structured Finance," under the equity method of accounting.
Accordingly, we recognize our percentage share of any income or loss of these
entities. Because the Trapeza entities are investment companies for accounting
purposes, such income or loss includes a "mark-to-market" adjustment to reflect
the net changes in value, including unrealized appreciation or depreciation, in
investments and swap agreements. Such value will be impacted by changes in the
underlying quality of the Trapeza entities' investments, and by changes in
interest rates. To the extent that the Trapeza entities' investments are
securities with a fixed rate of interest, increases in interest rates will
likely cause the value of the investments to fall and decreases in interest
rates will likely cause the value of the investments to rise. The Trapeza
entities' various interest rate hedges and swap agreements will also change in
value with changes in interest rates. In addition, as the equity interests that
we hold in the Trapeza CDO issuers are terminated, we obtain a return of capital
only after all payments are made on the CDOs. If there are defaults on the
collateral securities held by the Trapeza CDO issuers, our distributions and
return of capital upon liquidation may be reduced or eliminated. Accordingly,
our income or loss from our Trapeza investments, and from future similar CDO
issuer investments, may be volatile.
The primary or sole source of recovery for our real estate loans and
property interests is typically the underlying real property. Accordingly, the
value of our loans and property interests depends upon the value of that real
property. Many of the properties underlying our portfolio loans, while income
producing, do not generate sufficient revenues to pay the full amount of debt
service required under the original loan terms or have other problems. There may
be a higher risk of default with these loans as compared to conventional loans.
Loan defaults will reduce our current return on investment and may require us to
become involved in expensive and time-consuming bankruptcy, reorganization or
foreclosure proceedings.
24
Our loans, including those treated in our consolidated financial
statements as FIN 46 assets and liabilities, typically provide payment
structures other than equal periodic payments that retire a loan over its
specified term, including structures that defer payment of some portion of
accruing interest, or defer repayment of principal, until loan maturity. Where a
borrower must pay a loan balance in a large lump sum payment, its ability to
satisfy this obligation may depend upon its ability to obtain suitable
refinancing or otherwise to raise a substantial cash amount, which we do not
control. In addition, lenders can lose their lien priority in many
jurisdictions, including those in which our existing loans are located, to
persons who supply labor or materials to a property. For these and other
reasons, the total amount which we may recover from one of our loans may be less
than the total amount of the carrying value of the loan or our cost of
acquisition.
Declines in real property values generally and/or in those specific
markets where the properties underlying our portfolio loans are located could
affect the value of and default rates under those loans. Properties underlying
our loans may be affected by general and local economic conditions, neighborhood
values, competitive overbuilding, casualty losses and other factors beyond our
control. The value of real estate properties may also be affected by factors
such as the cost of compliance with, and liability under environmental laws,
changes in interest rates and the availability of financing. Income from a
property will be reduced if a significant number of tenants are unable to pay
rent or if available space cannot be rented on favorable terms. Operating and
other expenses of properties, particularly significant expenses such as real
estate taxes, insurance and maintenance costs, generally do not decrease when
revenues decrease and, even if revenues increase, operating and other expenses
may increase faster than revenues.
Many of our portfolio loans, including those treated in our
consolidated financial statements as FIN 46 assets and liabilities, are junior
lien obligations. Subordinate lien financing poses a greater credit risk,
including a substantially greater risk of nonpayment of interest or principal,
than senior lien financing. If we or any senior lender forecloses on a loan, we
will be entitled to share only in the net foreclosure proceeds after payment to
all senior lenders. It is therefore possible that we will not recover the full
amount of a foreclosed loan or the amount of our unrecovered investment in the
loan.
At September 30, 2004, our allowance for possible losses was $989,000,
which represents 2.1% of the book value of our investments in real estate loans
and property interest. We cannot assure you that this allowance will prove to be
sufficient to cover future losses, or that future provisions for losses will not
be materially greater than those we have recorded to date. Losses that exceed
our allowance for losses, or cause an increase in our provision for losses,
could materially reduce our earnings.
The loans in our portfolio, including those treated in our consolidated
financial statements as FIN 46 assets and liabilities, typically do not conform
to standard loan underwriting criteria. Many of our loans are subordinate loans.
As a result, our loans are relatively illiquid investments. We may be unable to
vary our portfolio in response to changing economic, financial and investment
conditions.
The existence of hazardous or toxic substances on a property will
reduce its value and our ability to sell the property in the event of a default
in the loan it underlies. Contamination of a real property by hazardous
substances or toxic wastes not only may give rise to a lien on that property to
assure payment of the cost of remediation, but also can result in liability to
us as a lender, or, if we assume ownership or management, as an owner or
operator, for that cost regardless of whether we know of, or are responsible
for, the contamination. In addition, if we arrange for disposal of hazardous or
toxic substances at another site, we may be liable for the costs of cleaning up
and removing those substances from the site, even if we neither own nor operate
the disposal site. Environmental laws may require us to incur substantial
expenses to remediate contaminated properties and may materially limit use of
these properties. In addition, future laws or more stringent interpretations or
enforcement policies with respect to existing laws may increase our exposure to
environmental liability.
25
Our income from our loans includes accretion of discount, which is a
non-cash item. For a discussion of accretion of discount, see "Business - Real
Estate- Accounting for Discounted Loans." For the years ended September 30,
2004, 2003 and 2002, accretion of discount, net of collection of interest, was
$1.9 million, $2.0 million and $3.2 million, respectively. We accrete income on
a loan to a maximum amount equal to the difference between our cost basis in the
loan and the present value of the estimated cash flows from the property
underlying the loan. If the actual cash flows from the property are less than
our estimates, or if we reduce our estimates of cash flows, our earnings may be
adversely affected. Moreover, if we sell a loan, or foreclose upon and sell the
underlying property, and the amount we receive is less than the amount of our
carrying cost, we will recognize an immediate charge to our allowance for losses
or, if that amount is insufficient to absorb the shortfall and provide for
possible losses on remaining real estate investments, our statement of
operations.
In addition, the property owners have obtained senior lien financing
with respect to eight loans, including three treated as FIN 46 entities' assets.
The senior loans are with recourse only to the properties securing them subject
to certain standard exceptions, which we have guaranteed. These exceptions
relate principally to the following:
o fraud or intentional misrepresentation in connection with the loan
documents;
o misapplication or misappropriation of rents, insurance proceeds or
condemnation awards during continuance of an event of default or, at
any time, of tenant security deposits or advance rents;
o payments of fees or commissions to various persons related to the
borrower or to us during an event of default, except as permitted by
the loan documents;
o failure to pay taxes, insurance premiums or specific other expenses,
failure to use property revenues to pay property expenses, and
commission of criminal acts or waste with respect to the property;
o environmental violations; and
o the undismissed or unstayed bankruptcy or insolvency of borrower.
Before fiscal 2000, we entered into a series of standby commitments
with some participants in our loans which obligate us to repurchase their
participations or substitute a performing loan if the borrower defaults. At
September 30, 2004, the participations as to which we had standby commitments
had aggregate outstanding balances of $6.0 million. At September 30, 2004, we
also were contingently liable under guarantees of $730,000 in mortgage loan
receivables connected with a discontinued operation and contingently liable
under guarantees of $4.0 million in standby letters of credit issued in
connection with Atlas America's, Atlas Pipeline's and our lease of office space
in New York City.
Risks Relating to Our Energy Business
Until we spin-off Atlas America, our future financial condition and
results of operations, and the value of our natural gas and oil properties, will
depend to a significant extent upon the market prices Atlas America receives for
its natural gas and oil. Natural gas and oil prices historically have been
volatile and will likely continue to be volatile in the future. Prices Atlas
America has received during its past three fiscal years for its natural gas have
ranged from a high of $6.16 per mcf in the quarter ended June 30, 2004 to a low
of $3.39 per mcf in the quarter ended December 31, 2001. Prices for natural gas
and oil are dictated by supply and demand. The factors affecting supply include:
o the availability of pipeline capacity;
o domestic and foreign governmental regulations and taxes;
o political instability or armed conflict in oil producing regions or
other market uncertainties; and
26
o the ability of the members of the Organization of Petroleum
Exporting Countries to agree to and maintain oil prices and
production controls.
The factors affecting demand include:
o weather conditions;
o the price and availability of alternative fuels;
o the price and level of foreign imports; and
o the overall economic environment.
These factors and the volatility of the energy markets make it
extremely difficult to predict future oil and gas price movements with any
certainty. Price fluctuations can materially adversely affect Atlas America
because:
o price decreases will reduce the amount of cash flow available to it
for drilling and production operations and for its capital
contributions to its drilling investment partnerships;
o price decreases may make it more difficult to obtain financing for
Atlas America's drilling and development operations through
sponsored drilling investment partnerships, borrowing or otherwise;
o price decreases may make some reserves uneconomic to produce,
reducing Atlas America's reserves and cash flow; and
o price decreases may cause the lenders under Atlas America's credit
facility to reduce its borrowing base because of lower revenues or
reserve values, reducing its liquidity and, possibly, requiring
mandatory loan repayment.
Further, oil and gas prices do not necessarily move in tandem. Because
approximately 92% of Atlas America's proved reserves are currently natural gas
reserves, it is more susceptible to movements in natural gas prices.
The amount of recoverable natural gas and oil reserves may vary
significantly from well to well. While the average estimated ultimate recovery
from Atlas America's wells is 150 mmcfe per well, recoverable natural gas from
individual wells ranges up to 1.556 bcfe. Atlas America may drill wells that,
while profitable on an operating basis, do not produce sufficient net revenues
to return a profit after drilling, operating and other costs are taken into
account. The geologic data and technologies available do not allow Atlas America
to know conclusively before drilling a well that natural gas or oil is present
or may be produced economically. The cost of drilling, completing and operating
a well is often uncertain. For example, Atlas America has in recent years
experienced increases in the cost of tubular steel as a result of rising steel
prices which will increase well costs. Further, Atlas America's drilling
operations may be curtailed, delayed or cancelled as a result of many factors,
including:
o title problems;
o environmental or other regulatory concerns;
o costs of, or shortages or delays in the availability of, oil field
services and equipment;
o unexpected drilling conditions;
o unexpected geological conditions;
o adverse weather conditions; and
o equipment failures or accidents.
27
Any one or more of the factors discussed above could reduce or delay
Atlas America's receipt of drilling and production revenues, thereby reducing
its earnings and could reduce revenues in one or more of its drilling investment
partnerships, which may make it more difficult for it to finance its drilling
operations through sponsorship of future partnerships.
As part of Atlas America's business strategy, Atlas America continually
seeks acquisitions of gas and oil properties and companies. It completed two
property acquisitions in fiscal 2001, one from Kingston Oil Corporation and one
from American Refining and Exploration Company, and has acquired two oil and gas
companies, Viking Resources in fiscal 1999 and The Atlas Group in fiscal 1998,
that owned substantial natural gas and oil properties. The successful
acquisition of natural gas and oil properties requires assessment of many
factors, which are inherently inexact and may be inaccurate, including the
following:
o future oil and natural gas prices;
o the amount of recoverable reserves;
o future operating costs;
o future development costs,
o costs and timing of plugging and abandoning wells; and
o potential environmental and other liabilities.
Atlas America's assessment will not necessarily reveal all existing or
potential problems, nor will it permit it to become familiar enough with the
properties to assess fully their capabilities and deficiencies. With respect to
properties on which there is current production, Atlas America may not inspect
every well, platform or pipeline in the course of our due diligence. Inspections
may not reveal structural and environmental problems such as pipeline corrosion
or groundwater contamination. Atlas America may not be able to obtain or recover
on contractual indemnities from the seller for liabilities that the seller
created. Atlas America may be required to assume the risk of the physical
condition of the properties in addition to the risk that the properties may not
perform in accordance with its expectations.
Atlas America bases its estimates of proved natural gas and oil
reserves and future net revenues from those reserves upon analyses that rely
upon various assumptions, including those required by the Securities and
Exchange Commission, as to natural gas and oil prices, taxes, development
expenses, capital expenses, operating expenses and availability of funds. Any
significant variance in these assumptions, and, with respect to Atlas America's,
assumptions concerning natural gas prices, could materially affect the estimated
quantity of its reserves. As a result, Atlas America's estimates of its proved
natural gas and oil reserves are inherently imprecise. Actual future production,
natural gas and oil prices, taxes, development expenses, operating expenses,
availability of funds and quantities of recoverable natural gas and oil reserves
may vary substantially from its estimates or estimates contained in the reserve
reports referred to elsewhere in this report. Atlas America's properties also
may be susceptible to hydrocarbon drainage from production by other operators on
adjacent properties. In addition, its proved reserves may be revised downward or
upward based upon production history, results of future exploration and
development, prevailing natural gas and oil prices, governmental regulation and
other factors, many of which are beyond its control.
At September 30, 2004, approximately 30% of Atlas America's estimated
proved reserves were undeveloped. Recovery of undeveloped reserves generally
requires significant capital expenditures and successful drilling operations.
The reserve data assumes that Atlas America will obtain the necessary capital
and conduct these operations successfully which, for the reasons discussed
elsewhere in this section, may not occur.
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Atlas America's proved reserves will decline as reserves are produced
unless it acquires or leases additional properties containing proved reserves,
successfully develops new or existing properties or identifies additional
formations with primary or secondary reserve opportunities on its properties. If
it is not successful in expanding its reserve base, its future natural gas and
oil production and drilling activities, the primary source of its energy
revenues, will decrease. Atlas America's ability to find and acquire additional
reserves depends on its generating sufficient cash flow from operations and
other sources of capital, principally sponsored drilling investment
partnerships, all of which are subject to the risks discussed elsewhere in this
subsection.
The growth of Atlas America's energy operations has resulted from both
its acquisition of energy companies and assets and from its ability to obtain
capital funds through its sponsored drilling investment partnerships. If Atlas
America is unable to identify acquisitions on acceptable terms, or cannot obtain
sufficient capital funds through sponsored drilling investment partnerships, it
may be unable to increase or maintain its inventory of properties and reserve
base, or be forced to curtail drilling, production or other activities. This
would result in a decline in its revenues. Agreements between us and Atlas
America included to preserve the tax-free nature of the proposed spin-off of
Atlas America impose material limitations on its ability to complete
acquisitions until after the spin-off, as described in "-Energy-General."
Under current federal tax laws, there are tax benefits to investing in
drilling investment partnerships such as those Atlas America sponsors, including
deductions for intangible drilling costs and depletion deductions. Changes to
federal tax laws that reduce or eliminate these benefits may make investment in
Atlas America's drilling investment partnerships less attractive and, thus,
reduce its ability to obtain funding from this significant source of capital
funds. Atlas America may be affected by the Jobs and Growth Tax Relief
Reconciliation Act of 2003, which reduced the maximum federal income tax rate on
long-term capital gains and qualifying dividends to 15% through 2008. These
changes may make investment in its drilling investment partnerships relatively
less attractive than investments in assets likely to yield capital gains or
qualif