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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2010

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number 000-50464

 

LECG CORPORATION

(Exact name of registrant as specified in its charter)

 

Delaware

 

81-0569994

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

 

 

 

80 Lancaster Avenue
Devon, Pennsylvania 19333

 

(610) 254-0700

(Address of principal executive offices, including zip code)

 

(Registrant’s telephone number, including area code)

 

2000 Powell Street, Suite 600

Emeryville, California 94608

(Former name, former address and formal fiscal year, if changed since last report)

 

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  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o  No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

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

 

As of October 29, 2010, there were 38,227,343 shares of the registrant’s common stock outstanding.

 

 

 



Table of Contents

 

LECG CORPORATION AND SUBSIDIARIES
FORM 10-Q
TABLE OF CONTENTS

 

PART I.

FINANCIAL INFORMATION

3

Item 1.

Financial Statements

 

 

Condensed Consolidated Balance Sheets as of September 30, 2010 and December 31, 2009

3

 

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2010 and 2009

4

 

Condensed Consolidated Statement of Changes in Stockholders’ Equity for the Nine Months Ended September 30, 2010

5

 

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2010 and 2009

6

 

Notes to the Condensed Consolidated Financial Statements

7

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

23

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

39

Item 4.

Controls and Procedures

40

 

 

 

PART II.

OTHER INFORMATION

41

Item 1.

Legal Proceedings

41

Item 1A.

Risk Factors

41

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

53

Item 3.

Defaults Upon Senior Securities

53

Item 4.

(Removed and Reserved)

53

Item 5.

Other Information

53

Item 6.

Exhibits

53

 

2


 


Table of Contents

 

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

LECG CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

 

 

 

September 30,

 

December 31,

 

 

 

2010

 

2009

 

 

 

(unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

7,029

 

$

13,044

 

Accounts receivable, net

 

109,333

 

85,451

 

Prepaid expenses

 

4,374

 

4,981

 

Signing, retention and performance bonuses - current portion

 

11,133

 

14,046

 

Income taxes receivable

 

 

13,498

 

Other current assets

 

4,537

 

2,207

 

Total current assets

 

136,406

 

133,227

 

Property and equipment, net

 

9,939

 

7,814

 

Goodwill

 

51,474

 

1,800

 

Other intangible assets, net

 

9,221

 

3,078

 

Signing, retention and performance bonuses

 

18,422

 

20,293

 

Deferred compensation plan assets

 

8,940

 

10,017

 

Deferred tax assets, net

 

5,981

 

5,731

 

Other long-term assets

 

7,640

 

8,851

 

Total assets

 

$

248,023

 

$

190,811

 

 

 

 

 

 

 

Liabilities and stockholders’ equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accrued compensation

 

$

41,859

 

$

45,363

 

Accounts payable and other accrued liabilities

 

15,935

 

8,823

 

Payable for business acquisitions - current portion

 

5,643

 

1,055

 

Deferred revenue

 

4,820

 

3,052

 

Debt

 

33,088

 

12,000

 

Deferred tax liabilities, net - current portion

 

6,313

 

5,731

 

Total current liabilities

 

107,658

 

76,024

 

Payable for business acquisitions

 

1,159

 

100

 

Deferred compensation plan obligations

 

9,215

 

10,163

 

Deferred rent

 

4,812

 

6,156

 

Other long-term liabilities

 

3,861

 

252

 

Total liabilities

 

126,705

 

92,695

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Series A 7.5% convertible redeemable preferred stock, $0.01 par value, 15,000,000 shares authorized; 6,313,131 and 0 shares outstanding at September 30, 2010 and December 31, 2009, respectively (liquidation preference and redemption values at September 30, 2010 and December 31, 2009 of $26,055 and $0, including cumulative dividends of $1,055 and $0, respectively)

 

26,055

 

 

 

 

 

 

 

 

Stockholders’ equity

 

 

 

 

 

Common stock, $.001 par value, 200,000,000 shares authorized, 38,215,579 and 25,895,679 shares outstanding at September 30, 2010 and December 31, 2009, respectively

 

38

 

26

 

Additional paid-in capital

 

212,567

 

174,917

 

Accumulated other comprehensive loss

 

(1,358

)

(690

)

Accumulated deficit

 

(115,984

)

(76,137

)

Total stockholders’ equity

 

95,263

 

98,116

 

Total liabilities and stockholders’ equity

 

$

248,023

 

$

190,811

 

 

See notes to the condensed consolidated financial statements.

 

3



Table of Contents

 

LECG CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)
(unaudited)

 

 

 

Three Months Ended September 30, 

 

Nine Months Ended September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Fee-based revenues, net

 

$

73,471

 

$

60,192

 

$

220,439

 

$

189,578

 

Reimbursable revenues

 

3,626

 

2,531

 

10,274

 

7,319

 

Revenues

 

77,097

 

62,723

 

230,713

 

196,897

 

Direct costs

 

55,262

 

45,116

 

165,027

 

142,844

 

Reimbursable costs

 

3,714

 

2,512

 

10,244

 

7,703

 

Cost of services

 

58,976

 

47,628

 

175,271

 

150,547

 

Gross profit

 

18,121

 

15,095

 

55,442

 

46,350

 

Operating expenses:

 

 

 

 

 

 

 

 

 

General and administrative

 

23,756

 

17,518

 

67,161

 

55,125

 

Depreciation and amortization

 

1,474

 

1,239

 

4,102

 

3,849

 

Restructuring charges

 

1,916

 

4,019

 

9,024

 

5,479

 

Goodwill impairment

 

1,800

 

 

1,800

 

 

Other impairments

 

417

 

8,719

 

3,417

 

9,939

 

Divestiture charges

 

533

 

124

 

533

 

1,863

 

Operating loss

 

(11,775

)

(16,524

)

(30,595

)

(29,905

)

Interest income

 

15

 

32

 

80

 

122

 

Interest expense

 

(1,082

)

(659

)

(5,182

)

(1,617

)

Other income (expense), net

 

304

 

(135

)

104

 

(581

)

Loss before income taxes

 

(12,538

)

(17,286

)

(35,593

)

(31,981

)

Income tax expense

 

2,310

 

47,393

 

3,199

 

42,948

 

Net loss

 

(14,848

)

(64,679

)

(38,792

)

(74,929

)

 

 

 

 

 

 

 

 

 

 

Series A convertible redeemable preferred dividends

 

480

 

 

1,055

 

 

 

 

 

 

 

 

 

 

 

 

Net loss attributable to common stockholders

 

$

(15,328

)

$

(64,679

)

$

(39,847

)

$

(74,929

)

 

 

 

 

 

 

 

 

 

 

Loss per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.41

)

$

(2.52

)

$

(1.17

)

$

(2.94

)

Diluted

 

$

(0.41

)

$

(2.52

)

$

(1.17

)

$

(2.94

)

 

See notes to the condensed consolidated financial statements.

 

4



Table of Contents

 

LECG CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY

(in thousands, except share data) (unaudited)

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

Additional

 

other

 

 

 

Total

 

 

 

Common stock

 

paid-in

 

comprehensive

 

Accumulated

 

stockholders’

 

 

 

Shares

 

Amount

 

capital

 

loss

 

deficit

 

equity

 

Balance at December 31, 2009

 

25,895,679

 

$

26

 

$

174,917

 

$

(690

)

$

(76,137

)

$

98,116

 

Proceeds from sale of stock - Employee Stock Purchase Plan

 

2,761

 

 

10

 

 

 

10

 

Issuance of restricted stock awards

 

1,012,000

 

1

 

10

 

 

 

11

 

Issuance of common stock to acquire businesses

 

10,927,869

 

11

 

33,319

 

 

 

33,330

 

Vesting of restricted stock units

 

377,228

 

 

 

 

 

 

Exercise of options

 

3,375

 

 

13

 

 

 

13

 

Cancellation of unvested restricted stock awards

 

(3,333

)

 

 

 

 

 

Equity-based compensation

 

 

 

4,298

 

 

 

4,298

 

Accrual of preferred stock dividends

 

 

 

 

 

(1,055

)

(1,055

)

Net loss

 

 

 

 

 

(38,792

)

(38,792

)

Foreign currency translation adjustment

 

 

 

 

(668

)

 

(668

)

Balance at September 30, 2010

 

38,215,579

 

$

38

 

$

212,567

 

$

(1,358

)

$

(115,984

)

$

95,263

 

 

 See notes to the condensed consolidated financial statements.

 

5



Table of Contents

 

LECG CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)
(unaudited)

 

 

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(38,792

)

$

(74,929

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Bad debt expense

 

2,191

 

99

 

Depreciation and amortization of property and equipment

 

3,075

 

3,315

 

Amortization of intangible assets

 

1,027

 

534

 

Amortization of signing, retention and performance bonuses

 

11,958

 

13,338

 

Deferred taxes

 

332

 

53,008

 

Equity-based compensation

 

4,298

 

2,463

 

Restructuring charges

 

9,024

 

1,234

 

Goodwill and other asset impairments

 

5,217

 

9,939

 

Amortization of debt issuance costs and discounted obligations

 

2,476

 

 

Divestiture charges

 

533

 

1,739

 

Changes in assets and liabilities, net of effects of business acquisitions:

 

 

 

 

 

Accounts receivable, net of deferred revenue

 

(5,129

)

(1,334

)

Signing, retention and performance bonuses paid

 

(12,006

)

(9,804

)

Prepaid and other current assets

 

1,296

 

1,809

 

Income taxes receivable

 

13,549

 

(6,380

)

Accounts payable and other accrued liabilities

 

(5,896

)

(1,682

)

Accrued compensation

 

(6,906

)

(11,890

)

Deferred compensation plan assets, net of liabilities

 

129

 

241

 

Other assets

 

(142

)

(730

)

Other liabilities

 

729

 

(97

)

Net cash used in operating activities

 

(13,037

)

(19,127

)

Cash flows from investing activities:

 

 

 

 

 

Cash acquired from SMART merger

 

9,242

 

 

Payments for business acquisitions and intangible assets

 

(1,109

)

(3,885

)

Divestiture payments

 

(640

)

(3,210

)

Purchases of property and equipment

 

(1,924

)

(1,053

)

Proceeds from note receivable

 

446

 

422

 

Proceeds from disposals of assets

 

100

 

619

 

(Increase) decrease in restricted cash and other

 

(1,666

)

8

 

Net cash provided by (used in) investing activities

 

4,449

 

(7,099

)

Cash flows from financing activities:

 

 

 

 

 

Borrowings under revolving credit facility

 

7,000

 

43,000

 

Repayments under revolving credit facility

 

(19,000

)

(27,000

)

Repayments of term debt

 

(9,961

)

 

Payment of loan fees

 

(202

)

(2,243

)

Proceeds from issuance of series A convertible redeemable preferred stock

 

25,000

 

 

Proceeds from option exercises or issuances of stock to employees and other

 

34

 

30

 

Net cash provided by financing activities

 

2,871

 

13,787

 

Effect of exchange rates on changes on cash

 

(298

)

175

 

Decrease in cash and cash equivalents

 

(6,015

)

(12,264

)

Cash and cash equivalents, beginning of period

 

13,044

 

19,510

 

Cash and cash equivalents, end of period

 

$

7,029

 

$

7,246

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid for interest

 

$

2,596

 

$

1,014

 

Cash paid for income taxes

 

$

1,815

 

$

1,900

 

 

 

 

 

 

 

Supplemental disclosures of non-cash investing and financing activities:

 

 

 

 

 

Note received for assets sold

 

$

417

 

$

 

Fair value of common stock issued in connection with SMART merger

 

$

33,330

 

$

 

Series A convertible redeemable preferred dividends

 

$

1,055

 

$

 

 

See notes to the condensed consolidated financial statements.

 

6


 


Table of Contents

 

LECG CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1.                                      Business and Basis of Presentation

 

LECG Corporation and its wholly-owned subsidiaries (collectively, the “Company”) is a global litigation, economics, consulting and business advisory, and governance, assurance, and tax expert service firm, with approximately 1,200 employees in 33 offices. The Company provides independent expert testimony, original authoritative studies, strategic financial advisory services, and innovative business consulting solutions to Fortune Global 500 corporations, middle market firms, AmLaw 100 law firms, and government agencies worldwide. The Company’s highly-credentialed experts and professional staff conduct economic and financial analyses and perform independent verification to provide objective opinions and advice that inform legislative, judicial, regulatory, and business decision makers.  The Company’s experts are renowned academics, former senior government officials, experienced industry leaders and seasoned consultants. Many of our consulting and business advisory professionals have come from national or international consulting and accounting firms, and have held senior-level executive or director positions prior to joining the Company. On March 10, 2010, the Company completed a merger (the “Merger”) with SMART Business Holdings, Inc. (“SMART”), a privately-held provider of business advisory services, which resulted in an expansion of services offered by the Company. See Note 2 to the condensed consolidated financial statements for further discussion regarding the Merger.

 

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. The notes to the consolidated financial statements contained in the Annual Report on Form 10-K for the year ended December 31, 2009 should be read in conjunction with these condensed consolidated financial statements. The December 31, 2009 balance sheet was derived from the audited balance sheet included in the Annual Report on Form 10-K for the year ended December 31, 2009. Operating results for the nine months ended September 30, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010.

 

Simultaneous with the consummation of the Merger, SMART’s majority shareholder, Great Hill Equity Partners III, LP (“Great Hill Partners”), made a $25.0 million cash investment into the Company in exchange for 6,313,131 shares of Series A Convertible Redeemable Preferred Stock (the “Preferred Stock”).  In connection with the Merger, the Company also repaid in full the $19.0 million outstanding under its then-existing credit facility, terminated the credit facility and became co-borrower with SMART under a $40.8 million term loan agreement which matures on March 31, 2011 (the “Term Loan Agreement”).  During the three and nine months ended September 30, 2010, the Company made principal payments of $3.0 million and $10.0 million, respectively, and interest payments of $0.8 million and $1.7 million, respectively, under the terms of the Term Loan Agreement.

 

The Term Loan Agreement contains various covenants, including financial covenants regarding a total funded debt to EBITDA ratio, a minimum fixed charge ratio, and minimum EBITDA and cash balance requirements.  At September 30, 2010, the Company was not in compliance with the EBITDA-related covenants, due to a combination of accelerated and increased integration-related expenses, the timing of realization of the related cost savings associated with these integration activities, a decrease in planned revenues driven by the continued weakness in the global economy and by expert attrition over the first half of 2010.  In addition to the steps being taken to secure refinancing of the term debt, the Company is currently evaluating alternatives to address the covenant non-compliance, including ongoing discussions with the Company’s current lenders to seek an amendment to reset the covenant ratios or to obtain a temporary waiver, as necessary, under the Term Loan Agreement.  The breach of the EBITDA-related covenants has resulted in a default under the Term Loan Agreement which, if not cured or waived by the lenders, permits the lenders to declare the full outstanding debt amount to be immediately due and payable, together with accrued and unpaid interest.  The Company would have insufficient liquidity to satisfy full repayment of the outstanding balance in a timely manner, if the remaining payments were accelerated.

 

Given the relatively near-term maturity of the term debt, in June 2010 the Company began the process of seeking and evaluating alternatives to refinance the term debt through various banks and other financial institutions and signed a non-binding term sheet in September 2010 with a commercial bank.  On November 8, 2010, the Company received a commitment letter from the bank.  The commitment letter provides for a multi-year, senior secured revolving credit facility (the “Proposed Revolving Credit Facility”) of up to $35 million.  The amount the Company is eligible to borrow under the Proposed Revolving Credit Facility will be subject to ongoing sufficiency of the Company’s defined borrowing base, which is comprised of our eligible billed and unbilled accounts receivable.  The Company intends to use the proceeds from the Proposed Revolving Credit Facility to refinance the amounts outstanding under the Term Loan Agreement and to support its ongoing working capital needs.  The Company is currently evaluating if the Proposed Revolving Credit Facility allows sufficient borrowings to satisfy these purposes.

 

Upon completing its evaluation of the commitment letter, the Company expects to execute the letter and proceed to closing on or before December 31, 2010.  The closing of the Proposed Revolving Credit Facility is subject to certain conditions, as well as a minimum borrowing base and credit facility availability as of the date of closing.  There is no assurance that the Company will be able to successfully close the Proposed Revolving Credit Facility by December 31, 2010 or at all.  In addition, the Company may conclude that the anticipated available borrowings under the Proposed Revolving Credit Facility are not sufficient to meet its anticipated needs, in which case the Company may seek additional funding in the form of subordinated debt or other sources as may be permitted under either the current Term Loan Agreement or the Proposed Revolving Credit Facility.  If the Company is unsuccessful in closing the Proposed Revolving Credit Facility and, if necessary, obtaining additional financing in place of or in addition to the Proposed Revolving Credit Facility, the Company does not anticipate that it will have sufficient liquidity to repay the amounts outstanding under the Term Loan Agreement.  In that event, the Company’s ability to obtain the working capital required for its operations would be uncertain, and its results of operations, financial condition and cash flows could be materially and adversely affected. The Company’s condensed consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

 

7



Table of Contents

 

2.                                      SMART Merger

 

In the Merger transaction, the Company acquired 100% of SMART’s outstanding stock in exchange for 10,927,869 shares of the Company’s common stock, which had a value of $33.3 million based on the March 10, 2010 closing stock price of $3.05. The Company also assumed $42.8 million of SMART debt. Simultaneous with the consummation of the Merger, SMART’s majority shareholder, Great Hill Partners made a $25.0 million cash investment into the Company in exchange for Preferred Stock. See Note 11 to the condensed consolidated financial statements for further discussion regarding the Preferred Stock. As a result of the issuance of the common stock and Preferred Stock, Great Hill Partners owns a significant portion of the Company’s outstanding voting shares. Following the Merger, the Company also relocated its corporate headquarters to Devon, Pennsylvania during the three months ended September 30, 2010. The Company completed the Merger primarily to expand its services offered, gain market share, increase its talent pool of business consultants, and expand its client base to include SMART’s Fortune 200 customers. The combined company expects to generate improved financial performance, with incremental revenues from integrated service opportunities and SMART’s financial advisory and business consulting practices including technology, business process improvement, compensation and benefits, accounting, actuarial and tax, and cost reductions from synergies.

 

The Merger was accounted for under Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 805, “Business Combinations” (“ASC 805”). Assets acquired and liabilities assumed were recorded at their estimated fair values as of the closing date of March 10, 2010 and represented the Company’s best estimate based on the data available at that time. The purchase price totaled $76.2 million and was allocated to SMART’s net tangible assets acquired and liabilities assumed, and to identifiable intangible assets based on their estimated fair values. The excess of the purchase price over the net tangible assets acquired and liabilities assumed and identifiable intangible assets was recorded as goodwill.

 

Total acquisition-related costs were $6.5 million, which included fees for legal, financial advisory, accounting, due diligence, tax, valuation, printing and other various services in connection with the transaction. The Company recorded $2.5 million of acquisition-related costs during the nine months ended September 30, 2010 in general and administrative expense within the condensed consolidated statement of operations and $4.0 million of acquisition-related costs prior to December 31, 2009 in general and administrative expense within the consolidated statement of operations.

 

The following table presents the adjusted purchase price allocation as of September 30, 2010 (in thousands):

 

Cash and cash equivalents

 

$

9,242

 

Accounts receivable

 

22,523

 

Prepaid expenses and other current assets

 

1,309

 

Property and equipment

 

4,415

 

Other assets

 

1,378

 

Accounts payable and other accrued liabilities

 

(11,760

)

Deferred compensation plan obligations and other liabilities

 

(3,138

)

Net tangible assets acquired

 

23,969

 

 

 

 

 

Identifiable intangible assets acquired

 

5,060

 

Goodwill

 

47,127

 

Debt assumed

 

(42,826

)

Total purchase price, net of debt assumed

 

$

33,330

 

 

Of the total estimated purchase price, $24.0 million has been allocated to the net tangible assets acquired and liabilities assumed, which included a fair value of $2.0 million related to unfavorable leases, $5.1 million has been allocated to the identifiable intangible assets acquired, which consist of the value assigned to SMART’s customer relationships of $4.9 million and trade name of $0.2 million, and $47.1 million has been allocated to goodwill, which primarily represents the value of the acquired workforce and the expected synergies from combining operations. The goodwill recorded as a result of the Merger is not expected to be deductible for tax purposes.

 

The following is a description of the methods used to determine the fair value of the intangible assets acquired from SMART:

 

·                  The value assigned to SMART’s customer relationships was established based on the excess earnings methodology of the income approach in order to capture the subject customers’ expected contribution to future earnings. In this method, value is estimated as the present value of the benefits anticipated from ownership of the subject intangible asset in excess of the returns required on the investment in the contributory assets necessary to realize those benefits. The forecast of revenue from existing customer relationships was based on

 

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the recent year’s sales and assumptions regarding future customer attrition and expected volume and price changes. The Company expects an average attrition rate of approximately 15% per year. Costs associated with the acquired customer revenue were based on specific margins and adjusted for the lower marketing expenses associated with sales to established customers. The excess earnings attributable to SMART’s customer relationships were discounted to present value using an estimated required rate of return.

 

·                  The value assigned to SMART’s trade name was determined based on an income approach which assumes that the acquirer will not pay royalties or license fees to use the trade name. The approach is known as the relief-from-royalty method and is applied to the appropriate levels of net revenues to calculate the royalty savings attributable to the ownership of the trade name. The present value of the after-tax cost savings at an appropriate discount rate indicates the value of the trade name.

 

The Company acquired SMART’s gross deferred tax assets of $24.8 million ($5.8 million net deferred tax assets), which consisted mostly of U.S. and foreign net operating loss carryforwards and tax basis in intangible assets. In addition, the Company recorded a deferred tax liability of $2.0 million related to amortizable intangible assets from the Merger. A full valuation allowance was recorded against certain deferred tax assets for SMART, as a result of the Company’s current assessment of its recoverability.

 

The accounts receivable balance at March 10, 2010 consists of gross contractual amounts of $24.2 million. The contractual cash flows not expected to be collected totaled $1.7 million.

 

The results of SMART have been included in the Company’s condensed consolidated financial statements since the Merger date. The following table presents SMART’s results included in the Company’s condensed consolidated statements of operations (in thousands):

 

 

 

July 1, 2010-

 

March 11, 2010-

 

 

 

September 30, 2010

 

September 30, 2010

 

Revenues

 

$

24,286

 

$

54,934

 

Net loss

 

$

(1,274

)

$

(7,410

)

Net loss attributable to common shareholders

 

$

(1,274

)

$

(7,410

)

 

The following summary of pro forma consolidated revenues, net loss and loss per share is presented as if the Merger had occurred at the beginning of each period presented. These unaudited pro forma results are not necessarily indicative of future earnings or earnings that would have been reported had the Merger been completed as presented (in thousands, except per share data):

 

 

 

Supplemental pro forma

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Revenues

 

$

77,097

 

$

87,641

 

$

249,162

 

$

275,159

 

Net loss

 

$

(14,848

)

$

(64,356

)

$

(40,973

)

$

(74,318

)

Net loss attributable to common shareholders

 

$

(15,328

)

$

(64,842

)

$

(42,393

)

$

(75,750

)

Loss per common share basic and diluted

 

$

(0.41

)

$

(1.77

)

$

(1.24

)

$

(2.07

)

 

3.                                      Summary of Significant Accounting Policies

 

Allowance for Bad Debts and Reserve for Unrealizable Revenue

 

Accounts receivable consists of unbilled and billed amounts due from clients, which are recognized net of a reserve for unrealizable revenue and an allowance for bad debts. The Company maintains a reserve for unrealizable revenue and an allowance for bad debts based on several factors, including the length of time receivables are past due, economic trends and conditions affecting the Company’s client base, specific knowledge of a client’s inability to meet its financial obligations, significant one-time events and historical write-off experience. The Company reviews the adequacy of its reserves on a quarterly basis. These estimates may be significantly different from actual results. If the financial condition of a client deteriorates in the future, impacting the client’s ability to make payments, an increase to the Company’s allowance might be required or its allowance may not be sufficient to cover actual write-offs.

 

The allowance for bad debts was $4.5 million and $2.0 million as of September 30, 2010 and December 31, 2009, respectively.

 

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The reserve for unrealizable revenue was $5.3 million and $3.5 million as of September 30, 2010 and December 31, 2009, respectively.

 

Loss Per Common Share

 

Basic loss per common share is computed by dividing the net loss attributable to common stockholders for the period by the weighted average number of common shares outstanding during the period. Diluted loss per common share is computed by dividing the net loss attributable to common stockholders for the period by the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares as determined by the treasury stock method are included in the diluted loss per common share calculation to the extent these shares are dilutive. If the Company has a net loss for the period, common equivalent shares are excluded from the denominator because their effect on net loss would be anti-dilutive.

 

The following is a reconciliation of net loss and the number of shares used in the basic and diluted loss per share computations (in thousands, except per share data):

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Net loss

 

$

(14,848

)

$

(64,679

)

$

(38,792

)

$

(74,929

)

Less: Series A convertible redeemable preferred share dividends

 

480

 

 

1,055

 

 

Net loss attributable to common shareholders

 

$

(15,328

)

$

(64,679

)

$

(39,847

)

$

(74,929

)

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding

 

 

 

 

 

 

 

 

 

Basic

 

37,070

 

25,654

 

34,136

 

25,515

 

Effect of dilutive stock options, unvested restricted stock and preferred shares

 

 

 

 

 

Diluted

 

37,070

 

25,654

 

34,136

 

25,515

 

Loss per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.41

)

$

(2.52

)

$

(1.17

)

$

(2.94

)

Diluted

 

$

(0.41

)

$

(2.52

)

$

(1.17

)

$

(2.94

)

 

Options to purchase approximately 4.7 million and 4.4 million shares were outstanding during the three and nine months ended September 30, 2010, respectively, but were not included in the computation of diluted loss per share because they were anti-dilutive. Options to purchase approximately 4.4 million and 5.2 million shares were outstanding during the three and nine months ended September 30, 2009, respectively, but were not included in the computation of diluted loss per share because they were anti-dilutive. The 6,313,131 shares of Preferred Stock were also not included in the computation of diluted loss per share because they were anti-dilutive.

 

Equity-Based Compensation

 

Stock option activity

 

Pursuant to the Merger agreement, the compensation committee of the Company’s board of directors approved the issuance of options to purchase 0.5 million shares of the Company’s common stock to employees of SMART. The options were granted effective April 1, 2010. During the nine months ended September 30, 2010, there were no other significant option grant issuances.

 

The weighted-average grant date fair value for stock options awarded to employees of SMART was $1.85 per share, resulting in a total value of $0.9 million, which will be expensed on a straight-line basis over a five year vesting period. The weighted-average exercise price of stock options granted to employees of SMART was $2.96 per share.

 

Black-Scholes assumptions

 

The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that employs the assumptions and inputs appearing in the table below. Certain inputs are presented as the range of values for that input used throughout the periods presented. Expected volatility is measured using the historical volatility of the Company’s stock price over the historical period corresponding to the vesting period of the options. The expected term is calculated using FASB ASC 718, “Compensation—Stock Compensation” (“ASC 718”), which permits the application of a “simplified” method based on the average of the vesting term and the contractual term of the option. The risk-free interest rate is based on published yields on U.S. Treasury securities with maturities commensurate with the expected term of the option. The assumptions used in calculating the fair value of options granted to employees of SMART are as follows:

 

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Expected volatility

 

64.0

%

Expected dividend rate

 

0

%

Expected term (in years)

 

6.5

 

Risk-free interest rate

 

3.0

%

 

There were no options granted during the three and nine months ended September 30, 2009.

 

Restricted stock activity

 

The compensation committee of the Company’s board of directors approved the issuance of 1.0 million shares of restricted stock to the Company’s chief executive officer effective May 3, 2010. The award provides that the restricted stock will vest over five years of continuous service with annual cliff vesting on the anniversary date of the grant in the following percentages: 10%, 15%, 20%, 25% and 30%. The grant date fair value of this restricted stock award was $3.3 million which will be expensed on a straight-line basis over the five-year vesting period.

 

Stock-based compensation expense

 

The following table summarizes equity-based compensation and its effect on direct costs, general and administrative expense and the Company’s loss (in thousands):

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Direct costs

 

$

760

 

$

1,006

 

$

2,774

 

$

2,963

 

General and administrative expense

 

632

 

(1,759

)

1,524

 

(500

)

Equity-based compensation effect on loss before income tax

 

1,392

 

(753

)

4,298

 

2,463

 

Income tax benefit

 

 

 

 

 

Equity-based compensation effect on loss

 

$

1,392

 

$

(753

)

$

4,298

 

$

2,463

 

 

Comprehensive Loss

 

Comprehensive loss represents the net loss plus other comprehensive gain (loss) income resulting from changes in foreign currency translation. The reconciliation of the Company’s comprehensive loss is as follows (in thousands):

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

2010

 

2009

 

Net loss

 

$

(14,848

)

$

(64,679

)

$

(38,792

)

$

(74,929

)

Foreign currency translation gain (loss)

 

192

 

348

 

(668

)

852

 

Comprehensive loss

 

$

(14,656

)

$

(64,331

)

$

(39,460

)

$

(74,077

)

 

4.                                      New Accounting Pronouncement

 

In July 2010, the FASB issued guidance to improve the disclosures about the credit quality of financing receivables and the allowance for credit losses.  The objectives of the enhanced disclosures are to provide information that will enable readers of financial statements to understand the nature of credit risk in financing receivables, how that risk is analyzed in determining the related allowance for loan losses, and changes to the allowance during the reporting period. The disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010, and the disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. The Company is currently determining the impact, if any, of this guidance on its condensed consolidated financial statements.

 

5.                                      Acquisition

 

On July 2, 2010, the Company acquired certain assets and assumed the lease-related liabilities of Bourne Business Consulting LLP and Bourne Business Consulting Limited (collectively, “Bourne”), a London-based independent business consultancy practice focusing on disputes, valuation, intellectual property and international tax matters. The purchase price was £4.1 million ($6.7

 

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million), of which £2.0 million will be paid on or before April 1, 2011 and £0.8 million will be paid on or before July 1, 2011. The remaining purchase price includes certain contingent consideration, payable at regular intervals if certain performance targets are achieved over the measurement period, which runs through June 30, 2014. The Company completed the acquisition primarily to expand its European presence for specialists in valuation, transfer pricing, intellectual property and tax consulting and advice as an extension to the finance, risk, process and operations services currently provided. As a result of the acquisition, the Company recorded goodwill of $4.4 million and other intangible assets of $2.0 million within the condensed consolidated balance sheet at September 30, 2010. The results of Bourne have been included in the Company’s Consulting and Governance segment within its condensed consolidated financial statements since the acquisition date. The acquisition of Bourne was not considered material for pro forma disclosure purposes.

 

6.                                      Restricted Cash

 

The Company had $1.7 million of restricted cash as of September 30, 2010. The restricted cash consisted of pledged bank deposits to collateralize outstanding letters of credit and is included in other long-term assets within the condensed consolidated balance sheet.

 

7.                                      Goodwill and Other Intangible Assets

 

A reconciliation of goodwill and accumulated goodwill impairment losses is as follows (in thousands):

 

 

 

Balance as of

 

Goodwill

 

Goodwill

 

Balance as of

 

 

 

December 31, 2009

 

Acquired

 

Impairment

 

September 30, 2010

 

Goodwill

 

$

121,663

 

$

51,474

 

$

 

$

173,137

 

Accumulated goodwill impairment losses

 

(119,863

)

 

(1,800

)

(121,663

)

Goodwill, net

 

$

1,800

 

$

51,474

 

$

(1,800

)

$

51,474

 

 

During each of the three and nine months ended September 30, 2010, the Company recorded a goodwill impairment charge of $1.8 million related to its March 2007 acquisition of The Secura Group, LLC (“Secura Group”).

 

Goodwill, net, increased by $49.7 million during the nine months ended September 30, 2010 due to the goodwill recorded as a result of the Merger and the Bourne acquisition, both of which were partially offset by the goodwill write-off related to the Secura Group. All of the Company’s goodwill as of September 30, 2010 is included within its Consulting and Governance segment within its condensed consolidated financial statements.

 

Other intangible assets are as follows (in thousands):

 

 

 

September 30, 2010

 

December 31, 2009

 

 

 

(in thousands)

 

 

 

Gross

 

 

 

 

 

Gross

 

 

 

 

 

 

 

Carrying

 

Accumulated

 

Net Book

 

Carrying

 

Accumulated

 

Net Book

 

 

 

Value (1)

 

Amortization (1)

 

Value

 

Value (1)

 

Amortization (1)

 

Value

 

Customer relationships

 

$

13,505

 

$

(4,760

)

$

8,745

 

$

6,495

 

$

(4,081

)

$

2,414

 

Other identifiable intangible assets

 

1,627

 

(1,151

)

476

 

1,626

 

(962

)

664

 

Total

 

$

15,132

 

$

(5,911

)

$

9,221

 

$

8,121

 

$

(5,043

)

$

3,078

 

 


(1)                                 Fully-amortized intangible assets are eliminated from the gross and accumulated amortization amounts in the period that the intangible asset is fully amortized.

 

Other intangible assets, net, increased by $6.1 million during the nine months ended September 30, 2010 primarily due to the Merger and the Bourne acquisition.

 

The aggregate amortization expense for the three and nine months ended September 30, 2010 was $0.5 million and $1.0 million, respectively. The expected future intangible asset amortization expense based on existing intangible assets as of September 30, 2010 is as follows (in thousands):

 

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2010 (three months)

 

$

356

 

2011

 

1,388

 

2012

 

1,313

 

2013

 

1,218

 

2014

 

1,028

 

2015

 

895

 

Thereafter

 

3,023

 

Total

 

$

9,221

 

 

8.                                      Accrued Compensation

 

Accrued compensation consists of the following (in thousands):

 

 

 

September 30,

 

December 31,

 

 

 

2010

 

2009

 

Expert compensation

 

$

15,760

 

$

15,967

 

Project origination fees

 

7,939

 

10,736

 

Vacation payable

 

4,137

 

2,098

 

Professional staff compensation

 

1,016

 

1,157

 

Administrative staff compensation

 

1,530

 

3,727

 

Signing, retention and performance bonuses payable

 

7,526

 

9,892

 

Other payroll liabilities

 

3,951

 

1,786

 

Total accrued compensation

 

$

41,859

 

$

45,363

 

 

9.                                      Debt

 

Debt outstanding is as follows:

 

 

 

September 30,

 

December 31,

 

 

 

2010

 

2009

 

 

 

(in thousands)

 

Term debt

 

$

30,801

 

$

 

Subordinated promissory notes

 

2,287

 

 

Credit facility

 

 

12,000

 

 

 

$

33,088

 

$

12,000

 

 

All debt as of September 30, 2010 is due within one year.

 

Term debt

 

In connection with the Merger, the Company entered into the Term Loan Agreement and became a co-borrower with SMART Business Advisory and Consulting, LLC under the Term Loan Agreement with Bank of Montreal (“BMO”) and the syndicate bank members. The Term Loan Agreement provides for a $40.8 million term loan which matures on March 31, 2011 and is guaranteed by the Company and its domestic subsidiaries. The Term Loan Agreement also allows the Company to seek up to an additional $10.0 million of subordinated debt, subject to certain repayment and maturity restrictions. The Term Loan Agreement required a $4.0 million principal payment at closing, and subsequent quarterly principal payments of $3.0 million beginning on June 30, 2010 through December 31, 2010. Also, cash balances in excess of certain amounts at each quarter-end must be used to make additional principal payments. The remaining outstanding principal balance is due in full on March 31, 2011. During the three and nine months ended September 30, 2010, the Company made principal payments of $3.0 million and $10.0 million, respectively, and interest payments of $0.8 million and $1.7 million, respectively.

 

Under the Term Loan Agreement, interest is payable quarterly at a rate consisting of the Base Rate plus 6.5%. The Base Rate is defined as the greater of (i) 3.0%, (ii) BMO’s prevailing prime commercial rate, (iii) the Federal Funds rate plus 0.5%, or (iv) LIBOR plus 1.5%. The interest rate in effect as of September 30, 2010 was 9.5%. During the nine months ended September 30, 2010, the Company paid $0.2 million in fees related to this Amendment, and will pay an additional $0.2 million on March 31, 2011. Also, if the Company achieves a trailing 12-month EBITDA of $15.0 million or greater, BMO is entitled to an additional payment of $1.0 million.

 

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The Term Loan Agreement contains various covenants, including financial covenants regarding a total funded debt to EBITDA ratio, a minimum fixed charge ratio, and minimum EBITDA and cash balance requirements. At September 30, 2010, the Company was not in compliance with the EBITDA-related covenants, due to a combination of accelerated and increased integration-related expenses, the timing of realization of the related cost savings associated with these integration activities, a decrease in planned revenues driven by the continued weakness in the global economy and by expert attrition over the first half of 2010. See Note 1 to the condensed consolidated financial statements for further discussion.

 

Subordinated promissory notes

 

In connection with the Merger, the Company also assumed subordinated promissory notes that are owed to certain active and former employees of SMART with an aggregate face amount of $2.3 million and a stated interest rate of 5.0%. These notes are payable no later than May 15, 2014.

 

Credit facility

 

At December 31, 2009, the Company had $12.0 million in outstanding borrowings under its revolving credit facility (the “Facility”) and $1.6 million in outstanding standby letters of credit. In connection with the Merger, the Company repaid in full the $19.0 million outstanding under the Facility and used $1.8 million to collateralize the outstanding letters of credit. The collateral is reflected as restricted cash in other long-term assets within the condensed consolidated balance sheet. The Facility was terminated, and the unamortized portion of capitalized loan fees, totaling $1.6 million, was expensed during the three months ended March 31, 2010.

 

10.                               Commitments and Contingencies

 

Legal proceedings

 

The Company is party to certain legal proceedings arising out of the ordinary course of business, including proceedings that involve claims of wrongful termination by experts and professional staff who formerly worked for the Company and claims for payment of disputed amounts relating to agreements in which the Company has acquired businesses. In accordance with GAAP, the Company has recorded a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, and has not recorded a liability for matters for which the outcome is uncertain and the Company is unable to estimate the amount or range of amounts that may become payable as a result of a judgment or settlement in such proceedings. In the Company’s opinion, the outcome of the proceedings for which it has not recorded a liability, individually and in the aggregate, would not have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.

 

Business acquisitions and certain expert hires

 

The Company made commitments in connection with its historical business acquisitions that require it to pay additional purchase consideration to the sellers if specified performance targets are met over a number of years, as specified in the related purchase agreements. These amounts are generally calculated and payable at the end of a calendar or fiscal year or other interval.

 

The accrued purchase price payable, the potential remaining purchase price payments at September 30, 2010, and the date of any final or potential payments by acquisition, are as follows (in thousands):

 

 

 

 

 

Accrued purchase

 

Potential remaining

 

Date of final

 

 

 

Acquisition

 

price payable at

 

purchase price

 

or potential

 

 

 

Date

 

September 30, 2010 (1)

 

payments (2)

 

payments

 

Bourne

 

July 2010

 

$

6,702

 

$

 

June 2014

 

Secura Group

 

March 2007

 

100

 

 

March 2011

 

Neilson Elggren

 

November 2005

 

 

1,500

 

December 2010

 

Total

 

 

 

$

6,802

 

$

1,500

 

 

 

 


(1)                                 Included in “Payable for business acquisitions” within the condensed consolidated balance sheet.

 

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(2)                                 Represents additional potential purchase price to be paid and goodwill to be recognized in the future if specified performance targets and conditions are met.

 

Significant expert retention and performance bonus contingencies

 

In the second half of 2009 and the first half of 2010, the Company entered into amended employment agreements with several experts and has made or is committed to make the following retention payments or performance-related payments if certain criteria are achieved at various measurement periods from 2010 to 2013. All such retention and performance payments will only be made if the expert is an employee of the Company on the payment date. Also, these payments are subject to amortization and repayment if the expert voluntarily terminates or is terminated for cause, generally from the time the payment is made through 2017. The table below presents the payments due by the years ending December 31 (in thousands):

 

Year

 

Retention

 

Performance

 

Total

 

2010 (three months)

 

$

1,875

 

$

 

$

1,875

 

2011

 

1,800

 

5,100

 

6,900

 

2012

 

500

 

1,725

 

2,225

 

2013

 

500

 

4,600

 

5,100

 

Total

 

$

4,675

 

$

11,425

 

$

16,100

 

 

Tax contingencies

 

In 2007, the Argentine taxing authority (“AFIP”) completed its audit of LECG Buenos Aires’ (“LECG BA”) income tax returns for 2003 and 2004, and its 2005 withholding tax return, and issued a notice to disallow certain deductions claimed for those years as well as a proposal to impose a withholding tax on certain payments made by LECG BA to LECG LLC, its U.S. parent company. The AFIP proposed to limit the deductibility of costs charged by LECG LLC to LECG BA for expert and staff services performed by Company personnel outside of Argentina on client-related matters, and to require withholding tax on certain payments by LECG BA for services rendered by Company personnel outside of LECG BA. In 2008, the Company elected to pay to the Argentine government $2.0 million for potential tax deficiencies and $1.3 million of potential interest in order to avoid the accrual of additional interest, while reserving its right to defend its position in Argentine tax court. The Company recorded the payments made to the AFIP, which equaled $2.8 million at September 30, 2010 due to the effect of foreign exchange, in other long-term assets within the condensed consolidated balance sheets.

 

On April 8, 2009, the Company was notified that the AFIP had terminated the penalty procedures relating to amounts previously paid for the 2003 and 2004 income tax and 2005 withholding tax deficiencies due to the passage of Argentine National Law No. 26.476 (Tax Moratorium). However, the Company may still be subject to penalties and interest on a potential underpayment of taxes related to the 2005 withholding tax return. Also, based on the results of the completed audit discussed above, the Company may receive additional notices for assessments of additional income taxes, penalties, and interest related to the Company’s 2005 and 2006 income tax returns and withholding taxes, penalties, and interest on payments made to the U.S. parent company to settle intercompany balances from June 2005 to December 2007.

 

On September 9, 2010, LECG BA-LECG LLC filed the refund claim with the National Tax Court due to the omission of the AFIP to decide the refund claim submitted by the Company in June 2008. On September 16, 2010, LECG BA was served notice of the denial by the AFIP of the refund claim filed in June 2008 (Resolución 122/2010). The denial was based on the formal objection to the evidence (documentation) presented by the Company, but the AFIP did not analyze the legal/tax arguments on which the Company based the refund claim. On October 7, 2010, the Company filed an appeal to Resolución 122/2010 with the National Tax Court.  In the Company’s opinion, none of these recent developments will have a financial statement impact as they are only administrative in nature and do not have any effect on the validity of the Company’s position in these matters.

 

If the National Tax Court ultimately finds in favor of the Argentine Government, the tax paid in connection with the potential income and withholding tax deficiency would qualify for a foreign tax credit on the Company’s U.S. tax return and would result in a deferred tax asset, the realization of which would be dependent upon the ability to utilize the foreign tax credit within the ten-year expiration period, beginning with the year to which the credit relates. The Company believes that it properly reported these transactions in its Argentine tax returns and has assessed that its position in this matter will be sustained. Accordingly, the Company has not recognized any additional tax liability in connection with this matter at September 30, 2010.

 

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11.                               Series A Convertible Redeemable Preferred Stock

 

Simultaneous with the consummation of the Merger, SMART’s majority shareholder, Great Hill Partners made a $25.0 million cash investment into the Company in exchange for 6,313,131 shares of Preferred Stock. The Preferred Stock is convertible share-for-share into the Company’s common stock and provides a cumulative 7.5% annual dividend, payable in additional shares of Preferred Stock or, at the Company’s option, in cash, as long as the Company has sufficient cash to make such distribution without breaching the terms of any contract for borrowed money indebtedness and such cash is legally available. Dividends accrue from the date of issuance of the Preferred Stock and are payable quarterly, in arrears, on the last day of March, June, September and December. Any accrued but unpaid dividends compound quarterly. The Company recorded $0.5 million and $1.1 million in dividends for the three and nine months ended September 30, 2010, respectively.

 

The dividend rate will increase from 7.5% per annum to 16% per annum if:

 

·                  The Company pays or declares any dividend or any other distribution on the common stock (other than dividends or distributions paid in additional shares of common stock) or, subject to limited exceptions, purchases, redeems or otherwise acquires any of the Company’s capital stock, unless and until full dividends on the Preferred Stock have been paid or declared and set apart;

 

·                  The Company incurs or permits any subsidiary to incur, directly or indirectly, any indebtedness for borrowed money that would result in the Company having, as of immediately following the incurrence of such indebtedness, indebtedness in excess of the greater of: (A) $75.0 million or (B) 2.5 times the amount of the Company’s EBITDA for the most recently completed fiscal year for which audited financial statements are available; or

 

·                  The Company does not make full payment of the redemption price, on any required redemption date, in connection with the election by any holder of shares of the Preferred Stock to cause the Company to redeem any shares of the Preferred Stock as described below.

 

The holders of a majority of the then outstanding shares of the Preferred Stock are permitted to waive the increase in the dividend rate with respect to any event and any such waiver will be binding on all holders of shares of the Preferred Stock.

 

Liquidation preference

 

If the Company was to voluntarily or involuntarily dissolve or liquidate, the holders of its Preferred Stock would be entitled to receive, prior and in preference to any distribution of the Company’s assets to the holders of its common stock, an amount per share equal to the greater of:

 

·                  $3.96 (as adjusted for any stock splits, stock dividends, combinations, recapitalizations or other similar transactions) plus all accrued and unpaid cumulative dividends on such share; or

 

·                  the amount which such holder of the Preferred Stock would have received assuming all shares of the Preferred Stock had been converted into common stock at the then applicable conversion price immediately prior to any such dissolution or liquidation.

 

If the Company has insufficient funds to distribute to the holders of its Preferred Stock, then all of the funds legally available for distribution by the Company shall be distributed pro rata among the holders of the Preferred Stock in proportion to the preferential amount each such holder is entitled to receive.

 

Deemed liquidations

 

Certain events will also be treated as a liquidation or dissolution of the Company, entitling the holders of the Preferred Stock to receive the liquidation payment described above. These events include: (i) a reorganization, consolidation or merger in which the Company is not the surviving entity; (ii) any other transaction in which the holders of the Company’s outstanding capital stock entitled to vote for the election of members of the Company’s board of directors immediately prior to such transaction do not hold a majority of the outstanding capital stock of the surviving or resulting entity entitled to vote for the election of members of the board of directors of the surviving or resulting entity; and (iii) any sale, conveyance or transfer of all or substantially all of the Company’s assets or business.

 

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Conversion

 

A holder of the Preferred Stock has the option to convert each share of the Preferred Stock at any time into shares of common stock, at an initial conversion price of $3.96 per share. The conversion price will be equitably adjusted in the event that the Company’s common stock is subdivided, combined or consolidated or in the event that the Company’s common stock is changed into the same or a different number of shares of any other class or classes of stock or other securities or property.

 

The Company may also require the conversion of the Preferred Stock, in whole or in part, by sending written notice to the holders of the Preferred Stock at any time after the second anniversary of the first date of issuance of shares of the Preferred Stock, if (i) the trading volume of the Company’s common stock averages at least 100,000 shares per trading day over the immediately preceding 30 trading day period (as adjusted for stock dividends, combination or splits with respect to the common stock), and (ii) the daily volume-weighted average price per share of the Company’s common stock for at least 20 of the 30 trading days preceding the date that the Company sends its notice requesting conversion exceeds two times the then current conversion price of the Preferred Stock.

 

Voting

 

Except as otherwise required by law, the holders of the Preferred Stock vote (on an as-if converted to common stock basis) on all matters voted on by the holders of common stock. In addition, the holders of the Preferred Stock vote separately as a class in certain circumstances, as set forth in the certificate of designations.

 

12.                              Restructuring Charges

 

As a result of the Merger, the Company identified and began pursuing opportunities for cost savings through office consolidations and workforce reductions, in order to improve operating efficiencies across the Company’s combined businesses. Part of the anticipated cost savings will result from the relocation of the Company’s corporate headquarters to Devon, Pennsylvania, which occurred during the three months ended September 30, 2010. During the nine months ended September 30, 2010, the Company continued with several other initiatives, including the consolidation of certain office locations, the closure of certain other offices, and a workforce reduction of administrative staff in the Emeryville office, all of which were partially offset by replacement hires in Devon, Pennsylvania.

 

During the three and nine months ended September 30, 2010, the Company recorded restructuring charges of $1.9 million and $9.0 million, respectively. Restructuring charges for the three months ended September 30, 2010 primarily consisted of $0.5 million of one-time termination benefits and $1.0 million of contract termination costs, while restructuring charges for the nine months ended September 30, 2010 primarily consisted of $3.7 million of one-time termination benefits and $4.2 million of contract termination costs. The Company does not anticipate any additional significant charges through early 2011. Of the $9.0 million in restructuring charges recorded during the nine months ended September 30, 2010, $7.4 million required current and future cash outlays and $1.6 million was non-cash related.

 

During the three and nine months ended September 30, 2009, the Company recorded restructuring charges of $4.0 million and $5.5 million, respectively, primarily related to contract termination costs and one-time termination benefits.

 

A reconciliation of the liability related to restructuring charges, which is included in other liabilities within the condensed consolidated balance sheets, is as follows (in thousands):

 

 

 

One-time

 

Contract

 

Other

 

 

 

 

 

termination

 

termination

 

associated

 

 

 

 

 

benefits

 

costs

 

costs

 

Total

 

Liability at December 31, 2009

 

$

 

$

1,605

 

$

 

$

1,605

 

SMART acquisition accounting

 

 

2,339

 

 

2,339

 

Restructuring charges

 

3,691

 

4,197

 

1,136

 

9,024

 

Cash payments

 

(2,758

)

(2,223

)

 

(4,981

)

Write-off of assets

 

 

 

(1,136

)

(1,136

)

Other adjustments

 

(51

)

544

 

 

493

 

Liability at September 30, 2010

 

$

882

 

$

6,462

 

$

 

$

7,344

 

 

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13.                              Other Impairments

 

During the three and nine months ended September 30, 2010, the Company recorded other impairment charges in the amount of $0.4 million and $3.4 million, respectively, primarily related to the impairment of certain non-trade receivables.

 

During the three and nine months ended September 30, 2009, the Company recorded other impairment charges in the amount of $8.7 million and $9.9 million, respectively, primarily related to the impairment of unearned bonuses and certain client receivables.

 

14.                              Divestiture Charges

 

During each of the three and nine months ended September 30, 2010, the Company recorded a charge of $0.5 million related to the divestiture of its Australia and New Zealand operations. The cash flows from the Australia and New Zealand operations were not material to the Company’s consolidated revenues, gross profit or net loss.

 

During the three months ended September 30, 2009, the Company recorded a charge of $0.1 million related to the divestiture of its Canadian practice. During the nine months ended September 30, 2009, the Company recorded a charge of $1.9 million related to the divestiture of its Canadian practice and the February 2008 divestiture of a portion of its practice in Milan, Italy.

 

15.                              Income Taxes

 

As a result of the Merger, the Company acquired SMART’s gross deferred tax assets of $24.8 million, which consisted mostly of U.S. and foreign net operating loss carryforwards, the use of which may be subject to limitations pursuant to Section 382 of the Internal Revenue Code, and tax basis in intangible assets. In addition, the Company recorded a deferred tax liability of $2.0 million related to amortizable intangibles from the Merger. A full valuation allowance was recorded against certain deferred tax assets for SMART, as a result of the Company’s current assessment of its recoverability.

 

The Company’s deferred tax assets are generally projected to reverse over the next one to thirty-three years. The extended reversal period is the result of significant income tax basis in intangible assets which were impaired for financial statement purposes during 2008. Tax amortization from these assets, if not offset with current taxable income, creates a net operating loss with a 20-year carryforward period for federal tax purposes. At September 30, 2010, the Company reviewed its deferred tax assets, as well as projected taxable income, for recovery using the “more likely than not” approach by assessing the available evidence surrounding its recoverability. The Company considered all available evidence, both positive and negative, including forecasts of future taxable income, tax planning strategies and past operating results, which included the net loss for the nine months ended September 30, 2010 and the years ended December 31, 2009 and 2008. Even though the Company projects income in future years, based on the current economic environment and the difficulty of accurately projecting taxable income, the Company determined that it was still “more likely than not” that its net deferred tax assets may not be realized. Consequently, as of September 30, 2010, the Company has retained a full valuation allowance against certain deferred tax assets, including those acquired in the Merger. However, SMART’s historical goodwill had a carryover tax basis as of the Merger date that resulted in an increase in the Company’s deferred tax liability in the amount of $0.3 million, which represents the tax amortization of such goodwill through September 30, 2010 for which there is no book deduction. The Company is precluded from considering this as a source of taxable income in the future which could then be offset by the Company’s deferred tax assets because there is no scheduled reversal of the deferred tax liability. In future periods, if the Company begins to generate taxable income and it determines that the deferred tax asset is more likely than not to be recoverable, the valuation allowance will be reversed. Any such reversal will result in a tax benefit in the period of reversal. The income tax expense for the nine months ended September 30, 2010 represents the amount of tax that the Company expects to pay on taxable income generated in foreign jurisdictions during the period, the deferred tax expense from the amortization of goodwill, the tax basis of which was carried over from SMART as a result of the Merger, and adjustments related to prior periods.

 

16.                              Fair Value of Financial Instruments

 

The following methods and assumptions are used to estimate the fair value of each class of financial instruments for which it is practical to estimate:

 

Cash and Cash Equivalents

 

The fair value of the Company’s cash and cash equivalents approximates the carrying value of the Company’s cash and cash equivalents, due to the short-term maturity of the cash equivalents.

 

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Debt

 

The fair value of the Company’s term debt approximates its carrying value, as it is variable-rate debt. The fair value of the Company’s subordinated promissory notes approximates its carrying value, as the effective interest rate is comparable to rates currently available to the Company for debt with a similar maturity and collateral requirement.

 

The estimated fair values of the Company’s financial instruments are as follows (in thousands):

 

 

 

September 30, 2010

 

December 31, 2009

 

 

 

Carrying

 

Fair

 

Carrying

 

Fair

 

 

 

Amount

 

Value

 

Amount

 

Value

 

Financial assets:

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

7,029

 

$

7,029

 

$

13,044

 

$

13,044

 

 

 

 

 

 

 

 

 

 

 

Financial liabilities:

 

 

 

 

 

 

 

 

 

Term debt

 

$

30,801

 

$

30,801

 

$

 

$

 

Subordinated promissory notes

 

2,287

 

2,287

 

 

 

Credit facility

 

 

 

12,000

 

12,000

 

 

17.                              Fair Value Measurements

 

ASC 820, “Fair Value Measurements and Disclosures,” establishes a hierarchy that prioritizes fair value measurements based on the types of inputs used for the various valuation techniques (market approach, income approach and cost approach). The levels of the hierarchy are described below:

 

·                  Level 1: Observable inputs such as quoted prices in active markets for identical assets or liabilities.

 

·                  Level 2: Inputs other than quoted prices that are observable for the asset or liability, either directly or indirectly; these include quoted prices for similar assets or liabilities in active markets, such as interest rates and yield curves that are observable at commonly-quoted intervals.

 

·                  Level 3: Unobservable inputs that reflect the reporting entity’s own assumptions, as there is little, if any, related market activity.

 

The Company’s assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of assets and liabilities and their placement within the fair value hierarchy.

 

The following table sets forth the assets and liabilities measured at fair value on a nonrecurring basis, by input level, in the condensed consolidated balances sheet at September 30, 2010 (in thousands):

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

Reduction in

 

 

 

Quoted Prices in

 

 

 

 

 

 

 

Fair Value

 

 

 

Active Markets for

 

Significant Other

 

Significant

 

 

 

Recorded at

 

Balance Sheet

 

Identical Assets or

 

Observable Inputs

 

Unobservable

 

September 30, 2010

 

September 30,

 

Location

 

Liabilities (Level 1)

 

(Level 2)

 

Inputs (Level 3)

 

Total

 

2010

 

Assets:

 

 

 

 

 

 

 

 

 

 

 

Goodwill

 

$

 

$

 

$

51,474

 

$

51,474

 

$

(1,800

)

 

 

 

 

 

 

 

 

 

 

$

(1,800

)

 

During each of the three and nine months ended September 30, 2010, the Company recorded a goodwill impairment charge of $1.8 million related to its March 2007 acquisition of the Secura Group. The goodwill impairment loss was measured as the difference between the carrying value of goodwill over its implied fair value.  In determining the implied fair value of goodwill, the Company first determined the fair value of the reporting unit to which the recorded goodwill was attributed and then allocated the reporting unit’s fair value to the individual assets and liabilities comprising the reporting unit based on the fair value of each asset and

 

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liability, determined as of the impairment testing date.  As the fair value of the reporting unit was less than the amounts allocated to its assets and liabilities, the implied fair value of goodwill for that reporting unit was zero.  The fair value of the reporting unit was determined using an income-based valuation methodology.

 

18.                              Segment Reporting

 

Prior to the Merger, the Company managed its business in two operating segments: Litigation, Forensics and Finance (formerly known as Finance and Accounting Services) and Economics and Dispute Resolution (formerly known as Economics Services). As a result of the Merger, the Company formed the Consulting and Governance segment, which is composed of the historical SMART consulting, business advisory, governance, assurance and tax practices. Below is a description of the Company’s three operating segments and their components:

 

Litigation, Forensics and Finance segment is composed of the electronic discovery, financial services, forensic accounting, healthcare, higher education, intellectual property, and international finance and accounting services sectors, as follows:

 

·                 Electronic discovery—provides direct collaboration with outside counsel, general counsel, corporate executives, bank examiners, bankruptcy trustees, forensic accountants, fraud examiners, and damages experts to deliver objective advice and testimony in all phases of the electronic discovery process including litigation preparedness, computer forensics and data analytics.

 

·                 Financial services—provides banking advisory services to leading financial service firms worldwide, addressing regulatory compliance, tax, and dispute resolution, and provides representation before applicable regulatory authorities and assists clients in regulatory compliance and SEC investigations and litigation.

 

·                 Forensic accounting—provides a broad range of expertise in accounting, auditing, computer forensics, regulatory (SEC), valuation, tax, and securities litigation, and offers a comprehensive mix of forensic accounting services, including internal investigations, fraud investigations, and when necessary, expert witness testimony.

 

·                 Healthcare—provides analyses and insight to clients confronting the uncertain healthcare environment by advising clients in the development of strategies, designing and understanding policies, and responding to legal and regulatory challenges, and offers a broad range of litigation support, management advisory, compliance, and expert testimony services.

 

·                 Higher education—provides strategic advice and management consulting to companies, universities, governments, and non-profit organizations with a focus on research and development and higher education.

 

·                 Intellectual property—provides expertise in areas such as capturing value from technological innovation and knowledge assets, estimating damages due to infringement or misappropriation, definition of markets and analyses of non-infringing alternatives, transfer pricing valuation studies, and valuation of businesses, opportunities, and intangible assets.

 

·                 International finance and accounting services—provides expert finance and accounting services to clients outside of the U.S., with particular emphasis on investigations, damages analysis and expert testimony in international arbitrations.

 

Economics and Dispute Resolution segment is composed of the energy and environment, global competition, labor and employment, regulated industries, and securities sectors, as follows:

 

·                 Energy and environment—provides expertise in the regulated energy, environment and natural resources industries.

 

·                 Global competition—offers a complete range of services on antitrust matters, including mergers and acquisitions, before courts and regulatory authorities around the world. The services involve the use of economic and statistical techniques to develop independent and objective analyses concerning issues related to merger reviews, monopolization claims, cartels, and quantification of damages. Experts in this area frequently testify before courts and appear before competition authorities in many jurisdictions around the world.

 

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·                 Labor and employment—provides litigation support, independent expert testimony, and business advisory services, including issues of statistical liability in discrimination, wrongful termination, and wage and hour claims.

 

·                 Regulated industries—provides expertise in a broad range of regulated industries, such as telecommunications, transportation and financial claims.

 

·                 Securities—specializes in the study of capital markets. These leading financial economists conduct independent analyses in disputes involving allegations of securities fraud, valuation of complex securities, and capital market transactions such as mergers and acquisitions.

 

Consulting and Governance segment is composed of the consulting and business advisory and the governance, assurance and tax sectors, as follows:

 

·                 Consulting and Business Advisory provides financial, operational and technology solutions, which improve business processes, leverage enabling technology and addresses human capital issues for corporate clients and government agencies in a broad range of industries including commercial services, healthcare, higher education, insurance, life sciences, and manufacturing.

 

·                 Governance, Assurance and Taxprovides broad-based accounting services to a broad range of clients in many industries, including insurance and financial services, commercial services, healthcare, higher education, life sciences and manufacturing. Tax solutions include a full range of federal, state and local, sales and use, personal property, real estate and international tax services. Other services include internal and external audit, compliance advisory, compensation and benefits services and actuarial services.

 

All segment revenues are generated from external clients and there are no intersegment revenues or expenses. The Company does not allocate general and administrative expense to its segments.

 

Summarized financial information by segment for the three and nine months ended September 30, 2010 and 2009 is as follows (in thousands, except percentages):

 

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Three months ended September 30,

 

 

 

2010

 

2009

 

 

 

Litigation,
Forensics
and
Finance

 

Economics
and
Dispute
Resolution

 

Consulting
and
Governance
(1)

 

Total

 

Litigation,
Forensics
and
Finance

 

Economics
and
Dispute
Resolution

 

Total

 

Fee-based revenues, net

 

$

30,751

 

$

17,551

 

$

25,169

 

$

73,471

 

$

35,384

 

$

24,808

 

$

60,192

 

Reimbursable revenues

 

1,556

 

978

 

1,092

 

3,626

 

1,766

 

765

 

2,531

 

Revenues

 

32,307

 

18,529

 

26,261

 

77,097

 

37,150

 

25,573

 

62,723

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Direct costs

 

23,082

 

15,790

 

16,390

 

55,262

 

26,518

 

18,598

 

45,116

 

Reimbursable costs

 

1,586

 

927

 

1,201

 

3,714

 

1,760

 

752

 

2,512

 

Cost of services

 

24,668

 

16,717

 

17,591

 

58,976

 

28,278

 

19,350

 

47,628

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

$

7,639

 

$

1,812

 

$

8,670

 

18,121

 

$

8,872

 

$

6,223

 

15,095

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross margin

 

23.6

%

9.8

%

33.0

%

23.5

%

23.9

%

24.3

%

24.1

%

Charges not allocated at the segment level:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative

 

 

 

 

 

 

 

23,756

 

 

 

 

 

17,518

 

Depreciation and amortization

 

 

 

 

 

 

 

1,474

 

 

 

 

 

1,239

 

Restructuring charges

 

 

 

 

 

 

 

1,916

 

 

 

 

 

4,019

 

Goodwill impairment

 

 

 

 

 

 

 

1,800

 

 

 

 

 

 

Other impairments

 

 

 

 

 

 

 

417

 

 

 

 

 

8,719

 

Divestiture charges

 

 

 

 

 

 

 

533

 

 

 

 

 

124

 

Interest income

 

 

 

 

 

 

 

(15

)

 

 

 

 

(32

)

Interest expense

 

 

 

 

 

 

 

1,082

 

 

 

 

 

659

 

Other (income) expense, net

 

 

 

 

 

 

 

(304

)

 

 

 

 

135

 

Loss before income taxes

 

 

 

 

 

 

 

$

(12,538

)

 

 

 

 

$

(17,286

)

 

 

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

 

 

Litigation,
Forensics
and
Finance

 

Economics
and
Dispute
Resolution

 

Consulting
and
Governance
(1)

 

Total

 

Litigation,
Forensics
and
Finance

 

Economics
and
Dispute
Resolution

 

Total

 

Fee-based revenues, net

 

$

100,559

 

$

65,794

 

$

54,086

 

$

220,439

 

$

108,478

 

$

81,100

 

$

189,578

 

Reimbursable revenues

 

4,721

 

2,730

 

2,823

 

10,274

 

4,940

 

2,379

 

7,319

 

Revenues

 

105,280

 

68,524

 

56,909

 

230,713

 

113,418

 

83,479

 

196,897

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Direct costs

 

76,641

 

52,695

 

35,691

 

165,027

 

84,451

 

58,393

 

142,844

 

Reimbursable costs

 

4,707

 

2,546

 

2,991

 

10,244

 

5,096

 

2,607

 

7,703

 

Cost of services

 

81,348

 

55,241

 

38,682

 

175,271

 

89,547

 

61,000

 

150,547

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

$

23,932

 

$

13,283

 

$

18,227

 

55,442

 

$

23,871

 

$

22,479

 

46,350

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross margin

 

22.7

%

19.4

%

32.0

%

24.0

%

21.0

%

26.9

%

23.5

%

Charges not allocated at the segment level:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative

 

 

 

 

 

 

 

67,161

 

 

 

 

 

55,125

 

Depreciation and amortization

 

 

 

 

 

 

 

4,102

 

 

 

 

 

3,849

 

Restructuring charges

 

 

 

 

 

 

 

9,024

 

 

 

 

 

5,479

 

Goodwill impairment

 

 

 

 

 

 

 

1,800

 

 

 

 

 

 

Other impairments

 

 

 

 

 

 

 

3,417

 

 

 

 

 

9,939

 

Divestiture charges

 

 

 

 

 

 

 

533

 

 

 

 

 

1,863

 

Interest income

 

 

 

 

 

 

 

(80

)

 

 

 

 

(122

)

Interest expense

 

 

 

 

 

 

 

5,182

 

 

 

 

 

1,617

 

Other (income) expense, net

 

 

 

 

 

 

 

(104

)

 

 

 

 

581

 

Loss before income taxes

 

 

 

 

 

 

 

$

(35,593

)

 

 

 

 

$

(31,981

)

 

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(1)         Results for the Consulting and Governance segment during the nine months ended September 30, 2010 represent activity from March 11, 2010 to September 30, 2010. Also, since the Merger was completed on March 10, 2010, no prior period comparative results are presented for this segment.

 

Revenues from the Company’s U.S. operations were $60.6 million and $186.1 million for the three and nine months ended September 30, 2010, respectively, while revenues from the Company’s international operations were $16.5 million and $44.6 million for the three and nine months ended September 30, 2010, respectively.

 

19.                              Subsequent Events

 

At September 30, 2010, the Company was not in compliance with the EBITDA-related covenants of its Term Loan Agreement, due to a combination of accelerated and increased integration-related expenses, the timing of realization of the related cost savings associated with these integration activities, a decrease in planned revenues driven by the continued weakness in the global economy and by expert attrition over the first half of 2010.

 

Also, given the relatively near-term maturity of the term debt, in June 2010 the Company began the process of seeking and evaluating alternatives to refinance the term debt through various banks and other financial institutions and signed a non-binding term sheet in September 2010 with a commercial bank.  On November 8, 2010, the Company received a commitment letter from the bank. See Note 1 to the condensed consolidated financial statements for further discussion of both the non-compliance with the debt covenants and an update on the refinancing efforts.

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and other parts of this Quarterly Report on Form 10-Q concerning our future business, operating and financial condition and statements using the terms “believes”, “expects”, “will”, “could”, “plans”, “anticipates”, “estimates”, “predicts”, “intends”, “potential”, “continue”, “should”, “may”, or the negative of these terms or similar expressions are “forward-looking” statements as defined in the Private Securities Litigation Reform Act of 1995. These statements are based upon our current expectations as of the date of this Report. There may be events in the future that we are not able to accurately predict or control that may cause actual results to differ materially from our current expectations. Information contained in these forward-looking statements is inherently uncertain, and actual performance is subject to a number of risks, including but not limited to, (1) our ability to successfully attract, integrate and retain our experts and professional staff, (2) dependence on key personnel, (3) successful management and utilization of professional staff, (4) dependence on growth of our service offerings, (5) our ability to maintain and attract new business, (6) our ability to maintain and comply with the covenants under our credit facility, (7) the cost and contribution of additional hires and acquisitions, (8) risks relating to the recent closing of our merger (the “Merger”) with SMART Business Holdings, Inc. (“SMART”) and our ability to successfully integrate the service offerings, professional staff, facilities and culture of the merged organizations, (9) successful administration of our business and financial reporting capabilities including maintaining effective internal control over financial reporting, (10) potential professional liability, (11) intense competition, (12) risks inherent in international operations, (13) risks inherent in successfully transitioning and managing our restructured business, and (14) risks relating to our ability to refinance our debt. Further information on these and other potential risks that could affect our financial results are described from time to time in our periodic filings with the Securities and Exchange Commission and include those set forth in this Report under Item 1A. “Risk Factors.” We cannot guarantee any future results, levels of activity, performance or achievement. We undertake no obligation to update any of these forward-looking statements after the date of this Report.

 

General

 

We are a global litigation, economics, consulting and business advisory, and governance, assurance, and tax expert service firm, with approximately 1,200 employees in 33 offices. We provide independent expert testimony, original authoritative studies, strategic financial advisory services, and innovative business consulting solutions to Fortune Global 500 corporations, middle market firms, AmLaw 100 law firms, and government agencies worldwide. Our highly-credentialed experts and professional staff conduct economic and financial analyses and perform independent verification to provide objective opinions and advice that inform legislative, judicial, regulatory, and business decision makers. Our experts are renowned academics, former senior government officials, experienced industry leaders and seasoned consultants. Many of our consulting and business advisory professionals have come from national or international consulting and accounting firms, and have held senior-level executive or director positions prior to joining us.

 

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Overview

 

As a result of our Merger, we increased our revenue base and expanded our areas of practice.  We also significantly increased our cost structure and assumed additional debt.

 

In connection with the Merger, we also repaid in full the $19.0 million outstanding under our then-existing credit facility, terminated the credit facility and became co-borrower with SMART under a $40.8 million term loan agreement which matures on March 31, 2011 (the “Term Loan Agreement”).  During the three and nine months ended September 30, 2010, we made principal payments of $3.0 million and $10.0 million, respectively, and interest payments of $0.8 million and $1.7 million, respectively, under the terms of the Term Loan Agreement.

 

Given the relatively near-term maturity of the term loan, in June 2010 we began the process of seeking and evaluating alternatives to refinance the term debt through various banks and other financial institutions and signed a non-binding term sheet in September 2010 with a commercial bank.  On November 8, 2010, we received a commitment letter from the bank.  The commitment letter provides for a multi-year, senior secured revolving credit facility (the “Proposed Revolving Credit Facility”) of up to $35 million.  The amount we are eligible to borrow under the Proposed Revolving Credit Facility will be subject to ongoing sufficiency of our defined borrowing base, which is comprised of our eligible billed and unbilled accounts receivable.  We intend to use the proceeds from the Proposed Revolving Credit Facility to refinance the amounts outstanding under the Term Loan Agreement and to support our ongoing working capital needs.  We are currently evaluating if the Proposed Revolving Credit Facility allows sufficient borrowings to satisfy these purposes.

 

Upon completing our evaluation of the commitment letter, we expect to execute the letter and proceed to closing on or before December 31, 2010.  The closing of the Proposed Revolving Credit Facility is subject to certain conditions, as well as minimum borrowing base and credit facility availability as of the date of closing.  There is no assurance that we will be able to successfully close the Proposed Revolving Credit Facility by December 31, 2010 or at all.  In addition, we may conclude that the anticipated available borrowings under the Proposed Revolving Credit Facility are not sufficient to meet our anticipated needs, in which case we may seek additional funding in the form of subordinated debt or other sources as may be permitted under either our current Term Loan Agreement or the Proposed Revolving Credit Facility.

 

The Term Loan Agreement contains various covenants, including financial covenants regarding a total funded debt to EBITDA ratio, a minimum fixed charge ratio, and minimum EBITDA and cash balance requirements.  At September 30, 2010, we were not in compliance with the EBITDA-related covenants, due to a combination of accelerated and increased integration-related expenses, the timing of realization of the related cost savings associated with these integration activities, a decrease in planned revenues driven by the continued weakness in the global economy and by expert attrition over the first half of 2010.  In addition to the steps being taken to finalize the Proposed Revolving Credit Facility, we are currently evaluating alternatives to address the covenant non-compliance, including ongoing discussions with our current lenders to seek an amendment to reset the covenant ratios or to obtain a temporary waiver, as necessary, under our Term Loan Agreement.  The breach of the EBITDA-related covenants has resulted in a default under the Term Loan Agreement.  If not cured or waived, the lenders under the Term Loan Agreement may declare the full outstanding debt amount to be immediately due and payable, together with accrued and unpaid interest.  We would have insufficient liquidity to satisfy full repayment of the outstanding balance in a timely manner, if the remaining payments were accelerated.

 

Recent Developments

 

Recent Acquisition

 

On July 2, 2010, we acquired certain assets and assumed the lease-related liabilities of Bourne Business Consulting LLP and Bourne Business Consulting Limited (collectively, “Bourne”), a London-based independent business consultancy practice focusing on disputes, valuation, intellectual property and international tax matters. The purchase price was £4.1 million ($6.7 million), of which £2.0 million will be paid on or before April 1, 2011 and £0.8 million will be paid on or before July 1, 2011. The remaining purchase price includes certain contingent consideration, payable at regular intervals if certain performance targets are achieved over the measurement period, which runs through June 30, 2014. We completed the acquisition primarily to expand our European presence for specialists in valuation, transfer pricing, intellectual property and tax consulting and advice as an extension to the finance risk, process and operations services currently provided. As a result of the acquisition, we recorded goodwill of $4.4 million and other intangible assets of $2.0 million within the condensed consolidated balance sheet at September 30, 2010. The results of Bourne have been included in our Consulting and Governance segment within our condensed consolidated financial statements since the acquisition date.

 

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Our Operations

 

We derive our revenue primarily from professional service fees that are billed at hourly rates on a time and expense basis. Revenue related to these services is recognized when the earnings process is complete and collection is reasonably assured. Revenues are recognized net of amounts estimated to be unrealizable based on several factors, including the historical percentage of write-offs due to fee adjustments for both unbilled and billed receivables.

 

Fee-based revenues, net are comprised of:

 

·                  fees for the services of our professional staff and subcontractors;

 

·                  fees for the services of our experts and affiliates; and

 

·                  realization allowance.

 

Reimbursable revenues are comprised of costs that are reimbursable by clients, including travel, document reproduction, subscription data services and other costs, and amounts we charge for services provided by others.

 

Direct costs are comprised of:

 

·                  salary, bonuses, employer taxes and benefits of all professional staff and salaried experts;

 

·                  compensation to experts based on a percentage of their individual professional fees;

 

·                  compensation to experts based on specified revenue and gross margin performance targets;

 

·                  compensation to subcontractors and affiliates;

 

·                  fees earned by experts and other business generators as project origination fees;

 

·                  amortization of signing bonuses and forgivable loans, retention bonuses, and performance bonuses, most of which are subject to vesting over time; and

 

·                  equity-based compensation.

 

Reimbursable costs are costs that are reimbursable by clients, including travel, document reproduction, subscription data services, and costs incurred for services provided by others.

 

Hourly fees charged by the professional staff that support our experts, rather than the hourly fees charged by our experts, generate a majority of our gross profit. Most of our experts are compensated based on a percentage of their billings from 30% to 100%, averaging approximately 72% of their individual billings on particular projects during the nine months ended September 30, 2010 and 2009. Such experts are paid when we have received payment from our clients. We refer to these experts as at-risk experts. Some of our experts are compensated based on a percentage of performance targets such as revenue or gross margin associated with engagements generated by an expert or a group of experts. Experts not on either of these compensation models are compensated under a salary plus performance-based bonus model. Managing Directors acquired in the Merger are compensated on a salary plus performance-based bonus model, which is dictated by the underlying performance of their respective business sectors. We make advance payments, or draws, to many of our non-salaried experts, and any outstanding draws previously paid to experts are deducted from the experts’ fee payments. We recognize an estimate of compensation expense for expert advances that we consider may ultimately be unrecoverable. In some cases, we guarantee an expert’s draw at the inception of their employment for a period of time, which is typically one year or less. In such cases, if the expert’s earnings do not exceed their draws within a reasonable period of time prior to the end of the guarantee period, we recognize an estimate of the compensation expense we will ultimately incur by the end of the guarantee period.

 

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Because of the manner in which we pay our experts, our gross profit is significantly dependent on the margin on our professional staff services. The number of professional staff and the level of experience of professional staff assigned to a project will vary depending on the size, nature and duration of each engagement. We manage our personnel costs by monitoring engagement requirements and utilization of the professional staff. As an inducement to encourage experts to utilize our professional staff, experts generally receive project origination fees. Such fees are based primarily on a percentage of the collected professional staff fees. Project origination fees can also include a percentage of the collected expert fees for those experts acting in a support role on an engagement. These fees have averaged 10% of professional staff revenues during each of the nine months ended September 30, 2010 and 2009. Experts are generally required to use our professional staff unless the skills required to perform the work are not available through us. In these instances we engage outside individual or firm-based consultants, who are typically compensated on an hourly basis. Both the revenue and the cost resulting from the services provided by these outside consultants are recognized in the period in which the services are performed.

 

Hiring and/or retaining experts sometimes involves the payment of upfront cash amounts. In some cases, the payment of a portion of an upfront amount is due at a future date. These types of upfront payments are recognized when the payment is made, the obligation to pay such amount is incurred, or on the execution date of the retention agreement, and are generally amortized over the period for which they are recoverable from the individual expert up to a maximum period of seven years.

 

We have also paid or are obligated to pay certain performance bonuses that are subject to recovery of unearned amounts if the expert were to voluntarily leave us, be terminated for cause, or fail to meet certain performance criteria prior to a specified date. Like signing and retention bonuses, these performance bonuses are amortized over the period for which unearned amounts are recoverable from the individual expert up to a maximum period of seven years, and we recognize such performance bonuses at the time we determine it to be more likely than not that the performance criteria will be met.

 

Most of our agreements allow us to recover signing, retention and performance bonuses from the employee if he or she were to voluntarily leave us or be terminated for cause prior to a specified date. However, for the purpose of recognizing expense, we amortize such signing, retention and performance bonuses over the shorter of the contractual recovery period or seven years. If an employee is involuntarily terminated, we generally cannot recover the unearned amount and we write off the unearned amount at the time of termination.

 

Critical Accounting Policies

 

We make certain judgments and use certain estimates and assumptions when applying accounting principles in the preparation of our condensed consolidated financial statements. The nature of the estimates and assumptions are material due to the levels of subjectivity and judgment necessary to account for highly uncertain factors or the susceptibility of such factors to change. We have identified the policies described below as critical accounting policies, which require us to make significant judgments, estimates and assumptions.

 

We believe that the current assumptions and other considerations used to estimate amounts reflected in our condensed consolidated financial statements are appropriate. However, if actual experience differs from the assumptions and other considerations used in estimating amounts reflected in our condensed consolidated financial statements, the resulting changes could have a material adverse effect on our results of operations and, in certain situations, could have a material adverse effect on our financial condition.

 

The development and selection of the critical accounting policies, and the related disclosures, have been reviewed with the Audit Committee of our Board of Directors.

 

Revenue recognition

 

Revenues include all amounts earned that are billed or billable to clients, including reimbursable expenses, and are reduced for amounts related to work performed that are estimated to be unrealizable. Expert revenues consist of revenues generated by experts who are our employees as well as revenues generated by experts who are independent contractors.

 

Revenues primarily arise from time and expense contracts, which are recognized in the period in which the services are performed. We also enter into certain performance-based contracts for which performance fees are dependent upon a successful outcome, as defined by the consulting engagement. Revenues related to performance-based fee contracts are recognized in the period when the earnings process is complete and we have received payment for the services performed under the contract. Revenues are also

 

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generated from fixed price contracts, which are recognized as the agreed upon services are performed. Fixed price and performance-based contract revenues are not a material component of total revenues.

 

We recognize revenues net of an estimate for amounts that will not be collected from the client due to fee adjustments. This estimate is based on several factors, including our historical percentage of fee adjustments and review of unbilled and billed receivables. These estimates are reviewed by us on a quarterly basis.

 

Accounts receivable, reserves for unrealizable revenue and allowance for bad debts

 

Accounts receivable consist of unbilled and billed amounts due from clients, which are recognized net of reserves for unrealizable revenue and allowances for bad debts. We maintain reserves for unrealizable revenue and allowance for bad debts based on several factors, including the length of time receivables are past due, economic trends and conditions affecting our client base, specific knowledge of a client’s inability to meet its financial obligations, significant one-time events and historical write-off experience. We review the adequacy of our reserves on a quarterly basis. These estimates may be significantly different from actual results. If the financial condition of a client deteriorates in the future, impacting the client’s ability to make payments, an increase to our allowance might be required or our allowance may not be sufficient to cover actual write-offs.

 

Equity-based compensation

 

We account for equity-based compensation under the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 718, Compensation—Stock Compensation (“ASC 718”). ASC 718 requires the recognition of the fair value of equity-based compensation in operations. The fair value of our stock option awards are estimated using a Black-Scholes option valuation model. This model requires the input of highly subjective assumptions and elections including expected stock price volatility and the estimated life of each award. In addition, the calculation of equity-based compensation costs requires that we estimate the number of awards that will be forfeited during the vesting period. Our forfeiture rate is based upon historical experience as well as anticipated employee turnover considering certain qualitative factors. The fair value of equity-based awards is amortized over the vesting period of the award and we elected to use the straight-line method for awards granted after the adoption of ASC 718.

 

Income taxes

 

We account for income taxes in accordance with FASB ASC 740, Income Taxes (“ASC 740”). The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We must assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. Judgment is required in assessing the future tax consequences of events that have been recognized within our condensed consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations or cash flows.

 

We account for uncertainty in income taxes recognized in our financial statements using a two-step approach. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is “more likely than not” that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely to be realized upon ultimate settlement.

 

Our deferred tax assets are generally projected to reverse over the next one to thirty-three years. The extended reversal period is the result of significant income tax basis in intangible assets which were impaired for financial statement purposes during 2008. Tax amortization from these assets, if not offset with current taxable income, creates a net operating loss with a 20-year carryforward period for federal tax purposes. At September 30, 2010, we reviewed our deferred tax assets, as well as future projected taxable income, for recovery using the “more likely than not” approach by assessing the available evidence surrounding recoverability. We considered all available evidence, both positive and negative, including forecasts of future taxable income, tax planning strategies and past operating results, which included a net loss for the nine months ended September 30, 2010 and the years ended December 31, 2009 and 2008. Even though we project income in future years, based upon the current economic environment and the difficulty of accurately projecting taxable income, we determined that it was still “more likely than not” that our net deferred tax assets may not be realized. Consequently, as of September 30, 2010, we retained a full valuation allowance against certain deferred tax assets, including those acquired in the Merger. However, SMART’s historical goodwill had a carryover tax basis as of the Merger date that resulted in an increase in our deferred tax liability in the amount of $0.3 million, which represents the tax amortization of such goodwill through September 30, 2010 for which there is no book deduction. We are precluded from considering this as a source of taxable income in the future which could then be offset by our deferred tax assets because there is no scheduled reversal of the deferred tax liability. In

 

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future years, if we begin to generate taxable income and we determine that the net deferred tax asset is recoverable, the valuation allowance will be reversed. Any such reversal will result in a tax benefit in the period of reversal. The income tax expense for the nine months ended September 30, 2010 represents the amount of tax that we expect to pay on taxable income generated in foreign jurisdictions during the period, the deferred tax expense from the amortization of goodwill, the tax basis of which was carried over from SMART as a result of the Merger, and adjustments related to prior periods.

 

Goodwill and other intangible assets

 

Goodwill relates to our business acquisitions, reflecting the excess of purchase price over fair value of identifiable net assets acquired. FASB ASC 350, Goodwill and Other Intangible Assets (“ASC 350”) requires that goodwill and intangible assets with indefinite lives not be amortized, but rather tested for impairment at least annually, or whenever events or changes in circumstances indicate that the carrying amounts of these assets may not be recoverable. Our annual impairment test is performed during the fourth quarter of each year, using an October 1st measurement date.

 

Factors that we consider important in determining whether to perform an impairment review on a date other than October 1st include significant underperformance relative to forecasted operating results, significant negative industry or economic trends, and permanent declines in our stock price and related market capitalization. If we determine that the carrying value of goodwill may not be recoverable, we will assess impairment based on a projection of discounted future cash flows for each reporting unit, or some other fair value measurement such as the quoted market price of our stock and the resulting market capitalization, and then measure the amount of impairment, if necessary, based on the difference between the carrying value of our reporting units’ assigned goodwill and its implied fair value. Determining the fair value of our reporting units and the implied fair value of a reporting unit’s assigned goodwill requires the use of estimates and assumptions and significant judgments, all of which could materially affect our determination and measurement of impairment. We tested our goodwill for impairment as of October 1, 2010, except for the goodwill recorded as a result of the Merger and the Bourne acquisition, and, as a result of that testing, recorded a goodwill impairment charge of $1.8 million during each of the three and nine months ended September 30, 2010 related to our March 2007 acquisition of The Secura Group, LLC (“Secura Group”). As both the Merger and the Bourne acquisition occurred in 2010, we scheduled our testing of the goodwill recorded as a result of the Merger and the Bourne acquisition for December 1, 2010.

 

Other intangible assets that are separable from goodwill and have determinable useful lives are valued separately and amortized over their expected useful lives. Other intangible assets primarily consist of customer relationships, and are generally amortized over ten months to ten years. We evaluate the recoverability of our other intangible assets over their remaining useful lives when changes in events or circumstances warrant an impairment review. If the carrying value of an intangible asset is determined to be impaired and unrecoverable over its originally estimated useful life, we will record an impairment charge to reduce the asset’s carrying value to its fair value and then amortize the remaining value prospectively over the revised remaining useful life. We generally determine the fair value of our intangible asset using a discounted cash flow model as quoted market prices for these types of assets are not readily available.

 

Results of Operations

 

Prior to our Merger, we managed our business in two operating segments: Economics and Dispute Resolution (formerly known as Economics Services) and Litigation, Forensics and Finance (formerly known as Finance and Accounting Services). As a result of the Merger, we formed a new Consulting and Governance segment composed of the historical SMART consulting and business advisory sector, and the governance, assurance and tax sector. The Chief Operating Decision Maker (our CEO) considers the key profit/loss measurement of these segments to be gross profit and gross margin. As such, only revenue, costs of services and gross margin are presented and discussed at the segment level.

 

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2010 Billable headcount

 

The following table summarizes the changes in the period-end billable headcount since December 31, 2009 and September 30, 2009:

 

 

 

 

 

 

 

 

 

Change since

 

 

 

September 30,

 

December 31,

 

September 30,

 

December 31, 2009

 

September 30, 2009

 

 

 

2010

 

2009

 

2009

 

Number

 

%

 

Number

 

%

 

Litigation, Forensics and Finance

 

310

 

415

 

447

 

(105

)

-25

%

(137

)

-31

%

Economics and Dispute Resolution

 

164

 

227

 

239

 

(63

)

-28

%

(75

)

-31

%

Consulting and Governance

 

447

 

 

 

447

 

100

%

447

 

100

%

Consolidated

 

921

 

642

 

686

 

279

 

43

%

235

 

34

%

 

Consolidated billable headcount increased since both September 30, 2009 and December 31, 2009, primarily due to the addition of billable headcount as a result of the Merger, partially offset by terminations in connection with our restructuring activities and voluntary attrition.

 

The retention of key experts and consultants, and the recruitment and hiring of additional experts, consultants and professional staff, both through direct hiring and through acquisitions, contributes to the success of our business. Our retention and hiring strategy is designed to promote our competitive advantage, to deepen our existing service offerings and to enter into new service areas when strategic opportunities arise. In connection with our retention and hiring efforts in the nine months ended September 30, 2010 and 2009, we paid signing, retention and performance bonuses of $12.0 million and $9.8 million, respectively, which will be amortized over periods ranging from one to seven years. Amortization of signing, retention and performance bonuses expense related to our billable headcount was $12.0 million and $13.3 million in the nine months ended September 30, 2010 and 2009, respectively.

 

Revenues and cost of services

 

The following table sets forth the consolidated revenues, cost of services, gross profit and gross margin and certain operating metrics for the three and nine months ended September 30, 2010 and 2009, respectively:

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

Change

 

2010

 

2009

 

Change

 

 

 

($ in thousands, except rate amounts)

 

Fee-based revenues, net

 

$

73,471

 

$

60,192

 

$

13,279

 

22.1

%

$

220,439

 

$

189,578

 

$

30,861

 

16.3

%

Reimbursable revenues

 

3,626

 

2,531

 

1,095

 

43.3

%

10,274

 

7,319

 

2,955

 

40.4

%

Revenues

 

77,097

 

62,723

 

14,374

 

22.9

%

230,713

 

196,897

 

33,816

 

17.2

%

Direct costs

 

55,262

 

45,116

 

10,146

 

22.5

%

165,027

 

142,844

 

22,183

 

15.5

%

Reimbursable costs

 

3,714

 

2,512

 

1,202

 

47.9

%

10,244

 

7,703

 

2,541

 

33.0

%

Cost of services

 

58,976

 

47,628

 

11,348

 

23.8

%

175,271

 

150,547

 

24,724

 

16.4

%

Gross profit

 

$

18,121

 

$

15,095

 

$

3,026

 

20.0

%

$

55,442

 

$

46,350

 

$

9,092

 

19.6

%

Gross margin

 

23.5

%

24.1

%

 

 

-0.6

%

24.0

%

23.5

%

 

 

0.5

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Billable headcount, period end

 

921

 

686

 

235

 

34.3

%

921

 

686

 

235

 

34.3

%

Average billable rate

 

$

261

 

$

305

 

$

(44

)

-14.4

%

$

289

 

$

310

 

$

(21

)

-6.8

%

 

Revenues

 

Fee-based revenues, net, increased by $13.3 million, or 22.1%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to the inclusion of fee-based revenues, net, generated by SMART. Fee-based revenues, net, for SMART were $24.3 million for the three months ended September 30, 2010. Partially offsetting this increase was a decrease in fee-based revenues, net, in the Litigation, Forensics and Finance and Economics and Dispute Resolution segments for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to a decrease in average billable headcount partially offset by an increase in the average billable rate. Average billable headcount, excluding the recently-acquired SMART employees, decreased from the three months ended September 30, 2009 to the three months

 

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ended September 30, 2010, primarily due to terminations in connection with our restructuring activities and voluntary attrition. The increase in the average billable rate was primarily caused by a shift in our revenue mix to higher-rate billable headcount.

 

Fee-based revenues, net, increased by $30.9 million, or 16.3%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to the inclusion of fee-based revenues, net, generated by SMART. Fee-based revenues, net, for SMART were $54.9 million since the Merger. Partially offsetting this increase was a decrease in fee-based revenues, net, in the Litigation, Forensics and Finance and Economics and Dispute Resolution segments for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to a decrease in average billable headcount partially offset by an increase in the average billable rate. Average billable headcount, excluding the recently-acquired SMART employees, decreased from the nine months ended September 30, 2009 to the nine months ended September 30, 2010, primarily due to terminations in connection with restructuring activities and voluntary attrition. The increase in the average billable rate was primarily caused by a shift in our revenue mix to higher-rate billable headcount.

 

Reimbursable revenues increased by $1.1 million, or 43.3%, and $3.0 million, or 40.4%, for the three and nine months ended September 30, 2010, respectively, as compared to the three and nine months ended September 30, 2009, primarily due to the inclusion of SMART reimbursable revenues.

 

Revenues from our international operations were $16.5 million for the three months ended September 30, 2010, which represented 21.4% of total revenues, as compared to 19.2% of total revenues for the three months ended September 30, 2009.  Revenues from our international operations increased by $4.5 million, or 37.0%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to an increase in business activity in our European operations and the inclusion of revenues generated by SMART’s international operations. Revenues for SMART’s international operations were $2.2 million for the three months ended September 30, 2010. Partially offsetting this increase was a decrease in our Asia Pacific operations during the three months ended September 30, 2010.

 

Revenues from our international operations were $44.6 million for the nine months ended September 30, 2010, which represented 19.3% of total revenues, as compared to 18.3% of total revenues for the nine months ended September 30, 2009. Revenues from our international operations increased by $8.7 million, or 24.1%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to an increase in business activity in our European operations and the inclusion of revenues generated by SMART’s international operations. Revenues for SMART’s international operations were $4.5 million for the nine months ended September 30, 2010. Partially offsetting this increase were decreases in revenues due to the divestiture of our Canadian practice in mid-2009 and a decrease in our Asia Pacific operations.

 

Cost of services

 

Direct costs increased by $10.1 million, or 22.5%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to the inclusion of direct costs attributable to SMART. Direct costs for SMART were $15.5 million for the three months ended September 30, 2010. Partially offsetting this increase was a $4.8 million decrease in expert and professional staff compensation primarily due to terminations in connection with our restructuring activities and voluntary attrition and a $0.6 million decrease in non-cash compensation primarily due to our restructuring activities.

 

Direct costs increased by $22.2 million, or 15.5%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to the inclusion of direct costs attributable to SMART. Direct costs for SMART were $34.8 million since the Merger. Partially offsetting this increase was a $10.9 million decrease in expert and professional staff compensation primarily due to terminations in connection with our restructuring activities and voluntary attrition and a $1.7 million decrease in non-cash compensation primarily due to our restructuring activities.

 

Reimbursable costs increased by $1.2 million, or 47.9%, and $2.5 million, or 33.0%, for the three and nine months ended September 30, 2010, respectively, as compared to the three and nine months ended September 30, 2009, primarily due to the inclusion of SMART reimbursable costs.

 

Gross margin

 

Gross profit was $18.1 million and $55.4 million for the three and nine months ended September 30, 2010, respectively, as compared to gross profit of $15.1 million and $46.4 million for the three and nine months ended September 30, 2009, respectively. Gross margin was 23.5% and 24.0% for the three and nine months ended September 30, 2010, respectively, as compared to gross margin of 24.1% and 23.5% for the three and nine months ended September 30, 2009, respectively.

 

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Table of Contents

 

Segment results

 

Litigation, Forensics and Finance

 

The following table sets forth the revenues, cost of services, gross profit and gross margin, and certain operating metrics for our Litigation, Forensics and Finance segment for the three and nine months ended September 30, 2010 and 2009, respectively:

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

Change

 

2010

 

2009

 

Change

 

 

 

($ in thousands, except rate amounts)

 

Fee-based revenues, net

 

$

30,751

 

$

35,384

 

$

(4,633

)

-13.1

%

$

100,559

 

$

108,478

 

$

(7,919

)

-7.3

%

Reimbursable revenues

 

1,556

 

1,766

 

(210

)

-11.9

%

4,721

 

4,940

 

(219

)

-4.4

%

Revenues

 

32,307

 

37,150

 

(4,843

)

-13.0

%

105,280

 

113,418

 

(8,138

)

-7.2

%

Direct costs

 

23,082

 

26,518

 

(3,436

)

-13.0

%

76,641

 

84,451

 

(7,810

)

-9.2

%

Reimbursable costs

 

1,586

 

1,760

 

(174

)

-9.9

%

4,707

 

5,096

 

(389

)

-7.6

%

Cost of services

 

24,668

 

28,278

 

(3,610

)

-12.8

%

81,348

 

89,547

 

(8,199

)

-9.2

%

Gross profit

 

$

7,639

 

$

8,872

 

$

(1,233

)

-13.9

%

$

23,932

 

$

23,871

 

$

61

 

0.3

%

Gross margin

 

23.6

%

23.9

%

 

 

-0.3

%

22.7

%

21.0

%

 

 

1.7

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Billable headcount, period end

 

310

 

447

 

(137

)

-30.6

%

310

 

447

 

(137

)

-30.6

%

Average billable rate

 

$

311

 

$

280

 

$

31

 

11.1

%

$

311

 

$

283

 

$

28

 

9.9

%

 

Revenues

 

Fee-based revenues, net, decreased by $4.6 million, or 13.1%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to a decrease in the average billable headcount primarily due to terminations in connection with restructuring activities, voluntary attrition and the divestiture of our Canadian practice in mid-2009, all of which was partially offset by an increase in the average billable rate primarily caused by a shift in our revenue mix to higher-rate billable headcount and an increase in revenues generated by sub-contractors.

 

Fee-based revenues, net, decreased by $7.9 million, or 7.3%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to a decrease in the average billable headcount primarily due to terminations in connection with restructuring activities and the divestiture of our Canadian practice in mid-2009, partially offset by an increase in the average billable rate primarily caused by a shift in our revenue mix to higher-rate billable headcount and an increase in revenue generated by sub-contractors.

 

Reimbursable revenues decreased by $0.2 million, or 11.9%, and $0.2 million, or 4.4%, for the three and nine months ended September 30, 2010, respectively, as compared to the three and nine months ended September 30, 2009, primarily due to a decrease in travel-related out-of-pocket expenses.

 

Cost of services

 

Direct costs decreased by $3.4 million, or 13.0%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to a $3.0 million decrease in expert and professional staff compensation primarily due to terminations in connection with our restructuring activities and voluntary attrition, partially offset by increased compensation earned by sub-contractors which generate higher revenues.

 

Direct costs decreased by $7.8 million, or 9.2%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to a $6.7 million decrease in expert and professional staff compensation primarily due to terminations in connection with our restructuring activities and voluntary attrition and a $1.0 million decrease in non-cash compensation due to our restructuring activities, both of which were partially offset by increased compensation earned by sub-contractors which generate higher revenues.

 

Reimbursable costs decreased by $0.2 million, or 9.9%, and $0.4 million, or 7.6%, for the three and nine months ended September 30, 2010, respectively, as compared to the three and nine months ended September 30, 2009, primarily due to a decrease in travel-related out-of-pocket expenses.

 

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Gross margin

 

Gross profit was $7.6 million and $23.9 million for the three and nine months ended September 30, 2010, respectively, as compared to gross profit of $8.9 million and $23.9 million for the three and nine months ended September 30, 2009, respectively. Gross margin was 23.6% and 22.7% for the three and nine months ended September 30, 2010, respectively, as compared to gross margin of 23.9% and 21.0% for the three and nine months ended September 30, 2009, respectively.

 

Economics and Dispute Resolution

 

The following table sets forth the revenues, cost of services, gross profit and gross margins, and certain operating metrics for our Economic and Dispute Resolution segment for the three and nine months ended September 30, 2010 and 2009, respectively:

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

Change

 

2010

 

2009

 

Change

 

 

 

($ in thousands, except rate amounts)

 

Fee-based revenues, net

 

$

17,551

 

$

24,808

 

$

(7,257

)

-29.3

%

$

65,794

 

$

81,100

 

$

(15,306

)

-18.9

%

Reimbursable revenues

 

978

 

765

 

213

 

27.8

%

2,730

 

2,379

 

351

 

14.8

%

Revenues

 

18,529

 

25,573

 

(7,044

)

-27.5

%

68,524

 

83,479

 

(14,955

)

-17.9

%

Direct costs

 

15,790

 

18,598

 

(2,808

)

-15.1

%

52,695

 

58,393

 

(5,698

)

-9.8

%

Reimbursable costs

 

927

 

752

 

175

 

23.3

%

2,546

 

2,607

 

(61

)

-2.3

%

Cost of services

 

16,717

 

19,350

 

(2,633

)

-13.6

%

55,241

 

61,000

 

(5,759

)

-9.4

%

Gross profit

 

$

1,812

 

$

6,223

 

$

(4,411

)

-70.9

%

$

13,283

 

$

22,479

 

$

(9,196

)

-40.9

%

Gross margin

 

9.8

%

24.3

%

 

 

-14.5

%

19.4

%

26.9

%

 

 

-7.5

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Billable headcount, period end

 

164

 

239

 

(75

)

-31.4

%

164

 

239

 

(75

)

-31.4

%

Average billable rate

 

$

384

 

$

349

 

$

35

 

10.0

%

$

369

 

$

354

 

$

15

 

4.2

%

 

Revenues

 

Fee-based revenues, net, decreased by $7.3 million, or 29.3%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to a decrease in the average billable headcount primarily due to our restructuring activities and voluntary attrition, partially offset by an increase in the average billable rate caused by a shift in our revenue mix to higher-rate billable headcount.

 

Fee-based revenues, net, decreased by $15.3 million, or 18.9%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to a decrease in the average billable headcount primarily due to our restructuring activities and voluntary attrition, partially offset by an increase in the average billable rate caused by a shift in our revenue mix to higher-rate billable headcount.

 

Reimbursable revenues increased by $0.2 million, or 27.8%, and $0.4 million, or 14.8%, for the three and nine months ended September 30, 2010, respectively, as compared to the three and months ended September 30, 2009, primarily due to an increase in travel-related out-of-pocket expenses.

 

Cost of services

 

Direct costs decreased by $2.8 million, or 15.1%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to a $2.6 million decrease in expert and professional staff compensation primarily due to terminations in connection with our restructuring activities and voluntary attrition.

 

Direct costs decreased by $5.7 million, or 9.8%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to a $5.0 million decrease in expert and professional staff compensation primarily due to terminations in connection with our restructuring activities and voluntary attrition.

 

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Reimbursable costs increased by $0.2 million, or 23.3%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to an increase in travel-related out-of-pocket expenses.

 

Reimbursable costs decreased by $0.1 million, or 2.3%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to a decrease in travel-related out-of-pocket expenses.

 

Gross margin

 

Gross profit was $1.8 million and $13.3 million for the three and nine months ended September 30, 2010, respectively, as compared to gross profit of $6.2 million and $22.5 million for the three and nine months ended September 30, 2009, respectively. Gross margin was 9.8% and 19.4% for the three and nine months ended September 30, 2010, respectively, as compared to gross margin of 24.3% and 26.9% for the three and nine months ended September 30, 2009, respectively.

 

Gross profit and gross margin decreased for the three and nine months ended September 30, 2010, as compared to gross profit and gross margin for the three and nine months ended September 30, 2009, as our restructuring activities and voluntary attrition affected our fee-based revenues more than our direct costs, primarily due to the fixed-cost component of some of our direct costs.

 

Consulting and Governance

 

The following table sets forth the revenues, cost of services, gross profit and gross margin, and certain operating metrics for our Consulting and Governance segment for the period July 1, 2010 to September 30, 2010 and for the period from March 11, 2010 to September 30, 2010, respectively:

 

 

 

For the period

 

 

 

July 1, 2010 to

 

March 11, 2010 to

 

 

 

September 30, 2010 (1)

 

September 30, 2010 (1)

 

 

 

($ in thousands, except rate amounts)

 

Fee-based revenues, net

 

$

25,169

 

$

54,086

 

Reimbursable revenues

 

1,092

 

2,823

 

Revenues

 

26,261

 

56,909

 

Direct costs

 

$

16,390

 

$

35,691

 

Reimbursable costs

 

1,201

 

2,991

 

Cost of services

 

17,591

 

38,682

 

Gross profit

 

$

8,670

 

$

18,227

 

Gross margin

 

33.0

%

32.0

%

 

 

 

 

 

 

Billable headcount, period end

 

447

 

447

 

Average billable rate

 

$

176

 

$

176

 

 


(1)        The results of Bourne have been included in our Consulting and Governance segment within our condensed consolidated financial statements since the acquisition date.

 

Revenues

 

Fee-based revenues, net, for the three months ended September 30, 2010 and for the period from March 11, 2010 to September 30, 2010 were $25.2 million and $54.1 million, respectively. Consulting and Governance derives substantially all of its revenue from fees for accounting and consulting services, which generally are billed based on time and expense, or less frequently, on a fixed-fee basis. Clients are typically invoiced on a monthly basis with revenue generally recognized as services are performed.

 

Reimbursable revenues for the three months ended September 30, 2010 and for the period from March 11, 2010 to September 30, 2010 were $1.1 million and $2.8 million, respectively. Reimbursable revenues are comprised of costs that are reimbursable by clients, including travel, document reproduction, subscription data services and other costs, as well as amounts that we charge for services provided by others.

 

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Table of Contents

 

Cost of services

 

Direct costs for the three months ended September 30, 2010 and for the period from March 11, 2010 to September 30, 2010 were $16.4 million and $35.7 million, respectively. The primary driver of direct cost is Managing Director and professional staff compensation cost, which includes salaries, variable compensation arrangements and bonuses.

 

Reimbursable costs for the three months ended September 30, 2010 and for the period from March 11, 2010 to September 30, 2010 were $1.2 million and $3.0 million, respectively. Reimbursable costs are costs that are reimbursable by clients, including travel, document reproduction, subscription data services, and other costs, as well as costs incurred for services provided by others.

 

Gross Margin

 

Gross profit was $8.7 million and $18.2 million for the three and nine months ended September 30, 2010, respectively, resulting in a gross margin of 33.0% and 32.0%, respectively.

 

Operating expenses

 

The following table sets forth our operating expenses for the three and nine months ended September 30, 2010 and 2009, respectively:

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

Change

 

2010

 

2009

 

Change

 

 

 

($ in thousands)

 

General and administrative

 

$

23,756

 

$

17,518

 

$

6,238

 

35.6

%

$

67,161

 

$

55,125

 

$

12,036

 

21.8

%

Depreciation and amortization

 

1,474

 

1,239

 

235

 

19.0

%

4,102

 

3,849

 

253

 

6.6

%

Restructuring charges

 

1,916

 

4,019

 

(2,103

)

-52.3

%

9,024

 

5,479

 

3,545

 

64.7

%

Goodwill impairment

 

1,800

 

 

1,800

 

100.0

%

1,800

 

 

1,800

 

100.0

%

Other impairments

 

417

 

8,719

 

(8,302

)

-95.2

%

3,417

 

9,939

 

(6,522

)

-65.6

%

Divestiture charges

 

533

 

124

 

409

 

329.8

%

533

 

1,863

 

(1,330

)

-71.4

%

Total operating expenses

 

$

29,896

 

$

31,619

 

$

(1,723

)

-5.4

%

$

86,037

 

$

76,255

 

$

9,782

 

12.8

%

 

General and administrative expense

 

General and administrative expense is comprised of compensation costs for our administrative staff, including salaries, bonuses, benefit costs and equity-based compensation; facility costs; legal, accounting and financial advisory fees; recruiting and training costs; marketing and advertising costs; travel expenses not reimbursed by clients; costs related to computers, telecommunications and supplies; and other operating expenses.

 

General and administrative expense increased by $6.2 million, or 35.6%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to the inclusion of general and administrative expense attributable to SMART. General and administrative expense for SMART was $7.8 million for the three months ended September 30, 2010. Partially offsetting this increase was a decrease in general and administrative expense primarily due to cost-saving measures and terminations in connection with our restructuring activities and voluntary attrition.

 

General and administrative expense increased by $12.0 million, or 21.8%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to the inclusion of general and administrative expense attributable to SMART. General and administrative expense for SMART was $17.2 million for the nine months ended September 30, 2010. Partially offsetting this increase was a decrease in general and administrative expense primarily due to cost-saving measures and terminations in connection with our restructuring activities and voluntary attrition.

 

Included in the general and administrative expense for the three and nine months ended September 30, 2010 are integration-related costs of $1.5 million and $3.7 million, respectively, of which $0.5 million and $1.5 million for the two periods, respectively, relate to internal billable resources who assisted in the integration efforts and will return to billable work upon completion of the integration.  Also included in the general and administrative expense for the three and nine months ended September 30, 2010  is an accrual of $0.9 million for certain legal contingencies, many of which arose prior to the quarter but have become probable of an unfavorable outcome during the three months ended September 30, 2010.

 

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Table of Contents

 

Depreciation and amortization expense

 

Depreciation and amortization expense increased by $0.2 million, or 19.0%, and $0.3 million, or 6.6%, for the three and nine months ended September 30, 2010, as compared to the three and nine months ended September 30, 2009, primarily due to incremental depreciation and amortization being recorded for the assets acquired as a result of the Merger.

 

Restructuring charges

 

As a result of the Merger, we identified and began pursuing opportunities for cost savings through office consolidations and workforce reductions, in order to improve operating efficiencies across our combined businesses. Part of the anticipated cost savings will result from the relocation of our corporate headquarters to Devon, Pennsylvania, which occurred during the three months ended September 30, 2010. During the nine months ended September 30, 2010, we continued with several other initiatives, including the consolidation of certain office locations, the closure of certain other offices, and a workforce reduction of administrative staff in the Emeryville office, all of which were partially offset by replacement hires in Devon, Pennsylvania.

 

During the three and nine months ended September 30, 2010, we recorded restructuring charges of $1.9 million and $9.0 million, respectively. Restructuring charges for the three months ended September 30, 2010 primarily consisted of $0.5 million of one-time termination benefits and $1.0 million of contract termination costs, while restructuring charges for the nine months ended September 30, 2010 primarily consisted of $3.7 million of one-time termination benefits and $4.2 million of contract termination costs. We do not anticipate any additional significant charges through early 2011. Of the $9.0 million in restructuring charges recorded during the nine months ended September 30, 2010, $7.4 million required current and future cash outlays and $1.6 million was non-cash related.

 

During the three and nine months ended September 30, 2009, we recorded restructuring charges of $4.0 million and $5.5 million, respectively, primarily related to contract termination costs and one-time termination benefits.

 

Goodwill impairment

 

During each of the three and nine months ended September 30, 2010, we recorded a goodwill impairment charge of $1.8 million related to our March 2007 acquisition of the Secura Group. The goodwill impairment loss was measured as the difference between the carrying value of goodwill over its implied fair value.  In determining the implied fair value of goodwill, we first determined the fair value of the reporting unit to which the recorded goodwill was attributed and then allocated the reporting unit’s fair value to the individual assets and liabilities comprising the reporting unit based on the fair value of each asset and liability, determined as of the impairment testing date.  As the fair value of the reporting unit was less than the amounts allocated to its assets and liabilities, the implied fair value of goodwill for that reporting unit was zero.  The fair value of the reporting unit was determined using an income-based valuation methodology.

 

Other impairments

 

During the three and nine months ended September 30, 2010, we recorded other impairment charges of $0.4 million and $3.4 million, respectively, primarily related to the impairment of certain non-trade receivables.

 

During the three and nine months ended September 30, 2009, we recorded other impairment charges of $8.7 million and $9.9 million, respectively, primarily related to the impairment of unearned bonuses and certain client receivables.

 

Divestiture charges

 

During each of the three and nine months ended September 30, 2010, we recorded a charge of $0.5 million related to the divestiture of our Australia and New Zealand operations. The cash flows from the Australia and New Zealand operations were not material to our consolidated revenues, gross profit or net loss.

 

During the three months ended September 30, 2009, we recorded a charge of $0.1 million related to the divestiture of our Canadian practice. During the nine months ended September 30, 2009, we recorded a charge of $1.9 million related to the divestiture of our Canadian practice and the February 2008 divestiture of a portion of our practice in Milan, Italy.

 

Interest income, interest expense and other expenses, net

 

The following table sets forth our interest income, interest expense and other expense, net for the three and nine months ended September 30, 2010 and 2009, respectively.

 

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Table of Contents

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

Change

 

2010

 

2009

 

Change

 

 

 

($ in thousands)

 

Interest income

 

$

15

 

$

32

 

$

(17

)

-53.1

%

$

80

 

$

122

 

$

(42

)

-34.4

%

Interest expense

 

(1,082

)

(659

)

(423

)

64.2

%

(5,182

)

(1,617

)

(3,565

)

220.5

%

Other income (expense), net

 

304

 

(135

)

439

 

-325.2

%

104

 

(581

)

685

 

-117.9

%

 

Interest expense increased by $0.4 million, or 64.2%, for the three months ended September 30, 2010, as compared to the three months ended September 30, 2009, primarily due to the higher average outstanding debt balances and higher average interest rates related to the debt assumed as a result of the Merger.

 

Interest expense increased by $3.6 million, or 220.5%, for the nine months ended September 30, 2010, as compared to the nine months ended September 30, 2009, primarily due to the write-off of $1.6 million of unamortized loan fees in connection with terminating our line of credit and the higher average outstanding debt balances and higher average interest rates related to the debt assumed as a result of the Merger.

 

Income taxes

 

Our income tax expense for the three and nine months ended September 30, 2010 and 2009, respectively, is as follows:

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

Change

 

2010

 

2009

 

Change

 

 

 

($ in thousands)

 

Income tax expense

 

$

2,310

 

$

47,393

 

$

(45,083

)

-95.1

%

$

3,199

 

$

42,948

 

$

(39,749

)

-92.6

%

 

The significant change in our provision for income taxes from 2009 to 2010 is the result of recording a full valuation allowance against our net deferred tax assets during the three months ended September 30, 2009. The income tax expense recorded during the three and nine months ended September 30, 2010 is attributable to certain foreign tax jurisdictions where we had pre-tax income and to the deferred tax expense from the tax amortization of goodwill, the tax basis of which was carried over from SMART as a result of the Merger. In addition, during the three months ended September 30, 2010, certain foreign and domestic returns were filed for the 2009 year, and any adjustment from the income tax provision previously recognized, impacted tax expense during the three months ended September 30, 2010.

 

LIQUIDITY AND CAPITAL RESOURCES

 

At September 30, 2010, we had approximately $7.0 million in cash and $109.3 million in net accounts receivable.  These amounts, together with cash generated by operations, including the timely collection of our billed accounts receivable and income tax receivables, are our primary current sources of liquidity.

 

On March 10, 2010, we completed the Merger.  Simultaneous with the consummation of the Merger, SMART’s majority shareholder, Great Hill Equity Partners III, LP, made a $25.0 million cash investment into the Company in exchange for 6,313,131 shares of Series A Convertible Redeemable Preferred Stock.

 

In connection with the Merger, we also repaid in full the $19.0 million outstanding under our then-existing credit facility, terminated the credit facility and entered into the Term Loan Agreement.  The Term Loan Agreement provides for a $40.8 million term loan which matures on March 31, 2011.  During the three and nine months ended September 30, 2010, we made principal payments of $3.0 million and $10.0 million, respectively, and interest payments of $0.8 million and $1.7 million, respectively, under the terms of the Term Loan Agreement.

 

Given the relatively near-term maturity of the term loan, in June 2010 we began the process of seeking and evaluating alternatives to refinance the term debt through various banks and other financial institutions and signed a non-binding term sheet in September 2010 with a commercial bank.  On November 8, 2010, we received a commitment letter from the bank.  The commitment letter provides for a multi-year, senior secured revolving credit facility (the “Proposed Revolving Credit Facility”) of up to $35 million.  The amount we are eligible to borrow under the Proposed Revolving Credit Facility will be subject to ongoing sufficiency of our defined borrowing base, which is comprised of our eligible billed and unbilled accounts receivable.  We intend to use the proceeds from the Proposed Revolving Credit Facility to refinance the amounts outstanding under the Term Loan Agreement and to support our ongoing working capital needs.  We are currently evaluating if the Proposed Revolving Credit Facility allows sufficient borrowings to satisfy these purposes.

 

Upon completing our evaluation of the commitment letter, we expect to execute the letter and proceed to closing on or before December 31, 2010.  The closing of the Proposed Revolving Credit Facility is subject to certain conditions, as well as a minimum borrowing base and credit facility availability as of the date of closing.  There is no assurance that we will be able to successfully close the Proposed Revolving Credit Facility by December 31, 2010 or at all.  In addition, we may conclude that the anticipated available borrowings under the Proposed Revolving Credit Facility are not sufficient to meet our anticipated needs, in which case we may seek additional funding in the form of subordinated debt or other sources as may be permitted under either our current Term Loan Agreement or the Proposed Revolving Credit Facility.

 

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The Term Loan Agreement contains various covenants, including financial covenants regarding a total funded debt to EBITDA ratio, a minimum fixed charge ratio, and minimum EBITDA and cash balance requirements.  At September 30, 2010, we were not in compliance with the EBITDA-related covenants, due to a combination of accelerated and increased integration-related expenses, the timing of realization of the related cost savings associated with these integration activities, a decrease in planned revenues driven by the continued weakness in the global economy and by expert attrition over the first half of 2010.  In addition to the steps being taken to finalize the Proposed Revolving Credit Facility, we are currently evaluating alternatives to address the covenant non-compliance, including ongoing discussions with our current lenders to seek an amendment to reset the covenant ratios or to obtain a temporary waiver, as necessary, under our Term Loan Agreement.  The breach of the EBITDA-related covenants has resulted in a default under the Term Loan Agreement.  If not cured or waived, the lenders under the Term Loan Agreement may declare the full outstanding debt amount to be immediately due and payable, together with accrued and unpaid interest.  We would have insufficient liquidity to satisfy full repayment of the outstanding balance in a timely manner, if the remaining payments were accelerated.

 

If we are unsuccessful in closing the Proposed Revolving Credit Facility and, if necessary, obtaining additional financing in place of or in addition to the Proposed Revolving Credit Facility, we do not anticipate that we will have sufficient liquidity to repay the amounts outstanding under the Term Loan Agreement.  In that event, our ability to obtain the working capital required for our operations would be uncertain, and our results of operations, financial condition and cash flows could be materially and adversely affected. Our condensed consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

 

Our primary financing needs in the future will be (i) to service the remaining principal and interest payments associated with the Term Loan Agreement, (ii) to continue funding our business operations, including our payroll-related costs, current operating lease commitments, signing, retention and performance bonuses, and (iii) to fund purchase price payments related to prior and future acquisitions.  We will also need to fund the balance of integration costs related to our Merger.  Further, the retention of key experts, the recruitment of additional experts and professional staff, and our expansion into new geographic and service areas are important elements of our business strategy to deepen our existing service offerings, and we expect to continue to recruit and hire experts and professional staff through a mix of individual hires, group hires and acquisitions.

 

The continued weakness in the global economy adds uncertainty to our anticipated revenues and earnings levels and to the timing of cash receipts, which are needed to support our operations.  In addition, cash payments for principal and interest under the Term Loan Agreement, Merger-related integration costs, future signing, retention and performance bonuses, and recruiting fees and acquisition payments could affect our cash needs.  We anticipate significant ongoing integration costs and the continued use of signing, retention and performance bonuses to recruit and retain expert talent and performance-based acquisition payments; however, we cannot predict the timing and magnitude of those events and opportunities.

 

As part of our Merger integration activities, we have made significant reductions in our operating expenses on a run-rate basis and we will continue to seek additional reductions for the remainder of 2010 and into 2011.  We are also seeking to reduce our direct costs through increased alignment of our compensation programs for billable professionals with both market conditions and our performance.  If our revenues decrease from their current levels, it may be necessary for us to implement further cost reductions beyond those currently anticipated.

 

We currently anticipate that we will retain all of our earnings, if any, for development of our business and do not anticipate paying any cash dividends in the foreseeable future.

 

Cash flows

 

 

 

Nine months ended September 30,

 

 

 

2010

 

2009

 

Change

 

 

 

($ in thousands)

 

Net cash provided by (used in):

 

 

 

 

 

 

 

 

 

Operating activities

 

$

(13,037

)

$

(19,127

)

$

6,090

 

31.8

%

Investing activities

 

4,449

 

(7,099

)

11,548

 

162.7

%

Financing activities

 

2,871

 

13,787

 

(10,916

)

-79.2

%

Effect of exchange rates on changes in cash

 

(298

)

175

 

(473

)

-270.3

%

Net decrease in cash and cash equivalents

 

$

(6,015

)

$

(12,264

)

$

6,249

 

-51.0

%

 

Operating activities

 

The $6.1 million decrease in cash used in operations over the prior period was the result of changes in our earnings and in the timing and amounts of working capital used during the respective periods. Significant uses of cash in our operations in the nine months ended September 30, 2010 were: a $38.8 million net loss, a $6.9 million decrease in accrued compensation, $12.0 million of

 

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signing, retention and performance bonuses paid during the period, and a $5.1 million increase in accounts receivable, net of deferred revenue. Partially offsetting these cash uses was an increase of $13.5 million in income taxes receivable.

 

Investing activities

 

Net cash provided by investing activities for the nine months ended September 30, 2010 consisted primarily of net cash received of $9.2 million from the Merger, partially offset by $1.9 million of capital expenditures, the majority of which related to the Merger, and an increase of $1.7 million in bank deposits held as collateral in favor of lessors under certain facility leases and certain vendors providing insurance services.

 

Financing activities

 

Net cash provided by financing activities for the nine months ended September 30, 2010 consisted primarily of a $25.0 million cash investment in connection with the Merger and $7.0 million of borrowings under our revolving line of credit, both of which were partially offset by principal repayments of $19.0 million outstanding under our then-existing credit facility and principal payments totaling $10.0 million related to the Term Loan Agreement that was assumed in connection with the Merger.

 

Commitments related to business acquisitions and certain expert hires

 

We made commitments in connection with our historical business acquisitions that require us to pay additional purchase consideration to the sellers if specified performance targets are met over a number of years, as specified in the related purchase agreements. These amounts are generally calculated and payable at the end of a calendar or fiscal year or other interval.

 

The accrued purchase price payable, the potential remaining purchase price payments at September 30, 2010, and the date of any final or potential payments by acquisition, are as follows (in thousands):

 

 

 

 

 

Accrued purchase

 

Potential remaining

 

Date of final

 

 

 

Acquisition

 

price payable at

 

purchase price

 

or potential

 

 

 

Date

 

September 30, 2010 (1)

 

payments (2)

 

payments

 

Bourne

 

July 2010

 

$

6,702

 

$

 

June 2014

 

Secura Group

 

March 2007

 

100

 

 

March 2011

 

Neilson Elggren

 

November 2005

 

 

1,500

 

December 2010

 

Total

 

 

 

$

6,802

 

$

1,500

 

 

 

 


(1)                                  Included in “Payable for business acquisitions” within our condensed consolidated balance sheet.

(2)                                  Represents additional potential purchase price to be paid and goodwill to be recognized in the future if specified performance targets and conditions are met.

 

Significant expert retention and performance bonus contingencies

 

In the second half of 2009 and the first half of 2010, we entered into amended employment agreements with several experts and are committed to make the following retention payments or performance-related payments if certain criteria are achieved at various measurement periods from 2010 to 2013. All such retention and performance payments will only be made if the expert is an employee on the payment date. Also, these payments are subject to amortization and repayment if the expert voluntarily terminates or is terminated for cause, generally from the time the payment is made through 2017. The table below presents the payments due by the years ending December 31 (in thousands):

 

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Year

 

Retention

 

Performance

 

Total

 

2010 (three months)

 

$

1,875

 

$

 

$

1,875

 

2011

 

1,800

 

5,100

 

6,900

 

2012

 

500

 

1,725

 

2,225

 

2013

 

500

 

4,600

 

5,100

 

Total

 

$

4,675

 

$

11,425

 

$

16,100

 

 

Tax contingencies

 

In 2007, the Argentine taxing authority (“AFIP”) completed its audit of LECG Buenos Aires’ (“LECG BA”) income tax returns for 2003 and 2004, and its 2005 withholding tax return, and issued a notice to disallow certain deductions claimed for those years as well as a proposal to impose a withholding tax on certain payments made by LECG BA to LECG LLC, our U.S. parent company. The AFIP proposed to limit the deductibility of costs charged by LECG LLC to LECG BA for expert and staff services performed by our personnel outside of Argentina on client-related matters, and to require withholding tax on certain payments by LECG BA for services rendered by our personnel outside of LECG BA. In 2008, we elected to pay to the Argentine government $2.0 million for potential tax deficiencies and $1.3 million of potential interest in order to avoid the accrual of additional interest, while reserving our right to defend our position in Argentine tax court. We recorded the payments made to the AFIP, which equaled $2.8 million at September 30, 2010 due to the effect of foreign exchange, in other long-term assets within the condensed consolidated balance sheets.

 

On April 8, 2009, we were notified that the AFIP had terminated the penalty procedures relating to amounts previously paid for the 2003 and 2004 income tax and 2005 withholding tax deficiencies due to the passage of Argentine National Law No. 26.476 (Tax Moratorium). However, we may still be subject to penalties and interest on a potential underpayment of taxes related to the 2005 withholding tax return. Also, based on the results of the completed audit discussed above, we may receive additional notices for assessments of additional income taxes, penalties, and interest related to our 2005 and 2006 income tax returns and withholding taxes, penalties, and interest on payments made to the U.S. parent company to settle intercompany balances from June 2005 to December 2007.

 

On September 9, 2010, LECG BA-LECG LLC filed the refund claim with the National Tax Court due to the omission of the AFIP to decide the refund claim submitted by us in June 2008. On September 16, 2010, LECG BA was served notice of the denial by the AFIP of the refund claim filed in June 2008 (Resolución 122/2010). The denial was based on the formal objection to the evidence (documentation) presented by us, but the AFIP did not analyze the legal/tax arguments on which we based the refund claim. On October 7, 2010, we filed an appeal to Resolución 122/2010 with the National Tax Court.  In our opinion, none of these recent developments will have a financial statement impact as they are only administrative in nature and do not have any effect on the validity of our position in these matters.

 

If the National Tax Court ultimately finds in favor of the Argentine Government, the tax paid in connection with the potential income and withholding tax deficiency would qualify for a foreign tax credit on our U.S. tax return and would result in a deferred tax asset, the realization of which would be dependent upon the ability to utilize the foreign tax credit within the ten-year expiration period, beginning with the year to which the credit relates. We believe that we properly reported these transactions in our Argentine tax returns and have assessed that our position in this matter will be sustained. Accordingly, we have not recognized any additional tax liability in connection with this matter at September 30, 2010.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Cash investment policy

 

Our cash investment policy requires us to invest any funds we have that are in excess of our current operating requirements. As of September 30, 2010, our cash and cash equivalents consisted primarily of non-interest bearing checking accounts. The recorded carrying amounts of cash and cash equivalents approximate fair value due to their short maturities.

 

Our cash investment guidelines are consistent with the objectives of preservation and safety of funds invested and ensuring liquidity. Eligible investments include money market accounts, US Treasuries, US Agency securities, commercial paper, municipal bonds, AAA-rated asset-backed securities, certificates of deposit and agency backed mortgage securities. We seek the highest quality credit rating available for each type of security used for investment purposes. Maturities are not to exceed 18 months.

 

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Interest rate risk

 

Our interest income and expense is sensitive to changes in the general level of interest rates in the United States, particularly since the majority of our cash investments are short-term in nature and the interest rate structure on our term loan is based on a variable rate such as LIBOR, federal funds or prime plus 6.5%. The variable rate portion is defined as the greater of (i) 3.0%, (ii) the Bank of Montreal’s prevailing prime commercial rate, (iii) the Federal Funds rate plus 0.5%, or (iv) LIBOR plus 1.5%. Due to the nature of our short-term investments and borrowings, we have concluded that we do not have material interest rate risk exposure.

 

Market risk

 

Our deferred compensation plan assets consist of the cash surrender value of company-owned variable universal life insurance policies. These insurance policies are held to insure against the sudden death of certain prior and current plan participants and as an offset to our liability to the plan participants. The cash surrender value for these insurance products at any given point in time is determined by the fair value of the underlying investment funds, referred to as insurance subaccounts, which are designed to emulate most of the characteristics of a retail mutual fund. The plan assets are reflected at fair value within our condensed consolidated balance sheets with changes recorded in other income/expense at the end of each reporting period. We are subject to market fluctuations and our net earnings has been and may in the future be affected by these fluctuations due to the timing of when we authorize the reallocation of insurance subaccounts to match changes to the plan participants’ investment allocations or when we have plan asset values that are greater than plan participant liabilities, which occasionally occurs due to the timing of participant distributions. If the fair value of the underlying investment funds of our deferred compensation plan assets were to fluctuate 10%, we believe that our consolidated financial position, results of operations and cash flows would not be materially affected.

 

Currency risk

 

We currently have operations in Argentina, Belgium, China, France, Hong Kong, Italy, Spain and the United Kingdom. Commercial bank accounts denominated in the local currency for operating purposes are maintained in each country. The functional currency in each location is the local currency. Fluctuations in exchange rates of the U.S. dollar against foreign currencies can and have resulted in foreign exchange translation gains and losses. We had an unrealized foreign currency translation loss of $0.7 million during the nine months ended September 30, 2010. Our realized foreign currency transaction gains and losses were not significant during the three and nine months ended September 30, 2010.

 

If exchange rates on such currencies were to fluctuate 10%, we believe that our consolidated financial position, results of operations and cash flows would not be materially affected.

 

ITEM 4. CONTROLS AND PROCEDURES

 

Evaluation of disclosure controls and procedures

 

Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this Quarterly Report.  Disclosure controls and procedures are designed to reasonably assure that information required to be disclosed in our reports filed under the Exchange Act, such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms.  Disclosure controls and procedures are also designed to reasonably assure that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of September 30, 2010, our disclosure controls and procedures were effective.

 

Our management, including our Chief Executive Officer and our Chief Financial Officer, do not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud.  Any system of controls, however well-designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system will be met.  In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events.  Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within our Company have been detected.

 

Changes in internal control over financial reporting

 

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, also conducted an evaluation of our internal control over financial reporting to determine whether any change occurred during the third fiscal quarter of 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. The evaluation accompanied the integration efforts initiated by our management following our merger (the “Merger”) with SMART Business Holdings, Inc. (“SMART”) on March 10, 2010.  During the third fiscal quarter of 2010, changes in the internal control over financial reporting were implemented in the following areas:

 

·      Because SMART was not a public company prior to the Merger, we are extending our Sarbanes-Oxley compliance program to cover the operations of SMART.

 

·      The Merger added a new segment to our business of significant size in relation to the rest of our operations.  We added more than 500 employees and approximately $100 million of annualized revenue.  The segment had different, and sometimes incompatible reporting systems, controls and procedures.  We are harmonizing the reporting systems, controls and procedures across all of our segments.

 

 

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·      We are harmonizing the information technology systems across the merged companies.

 

·      Prior to and after the Merger, we have placed substantial reliance on third party providers to assist us with tax compliance and related accounting and financial reporting.  During the third fiscal quarter of 2010, we have added internal expertise to oversee and review the work product prepared by our third party providers.

 

·      Following the Merger, we also relocated our corporate headquarters to Devon, Pennsylvania during the three months ended September 30, 2010. The move and consolidation included our human resources, finance and accounting, information technology, conflict clearance and legal departments. Certain key employees critical to our financial reporting and internal control environment prior to this relocation did not relocate to the new corporate headquarters and left the Company.  New leaders of the applicable departments have assumed these roles and responsibilities, and we have and will continue to evaluate and modify the impact of these changes on our operating processes and controls, as appropriate.

 

We face risks and may encounter difficulties as we implement these changes.  Please see “Risk Factors” for further discussion.

 

PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

We are party to certain legal proceedings arising out of the ordinary course of business, including proceedings that involve claims of wrongful termination by experts and professional staff who formerly worked for us and claims for payment of disputed amounts relating to agreements in which we have acquired businesses. In accordance with United States generally accepted accounting principles, we have recorded a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, and have not recorded a liability for matters for which the outcome is uncertain and we are unable to estimate the amount or range of amounts that may become payable as a result of a judgment or settlement in such proceedings. In our opinion, the outcome of the proceedings for which we have not recorded a liability, individually and in the aggregate, would not have a material adverse effect on our business, financial position, results of operations or cash flows.

 

ITEM 1A. RISK FACTORS

 

Set forth below are certain risks and uncertainties that affect our business and that could cause our actual results to differ materially from the results contemplated by forward-looking statements that we may make in: our press releases; conference calls and other communications with our investors; and in our reports filed with the Securities and Exchange Commission, including those contained in this Report. The occurrence of any of the following risks could harm our business, financial condition, results of operations or cash flows. In that case, the market price of our common stock could decline, and stockholders may lose all or part of their investment. The markets and economic environment in which we compete is constantly changing, and it is not possible to predict or identify all of the potential risk factors. Additional risks and uncertainties not presently known to us or that we do not currently consider to be material could also impair our operations.

 

Risks relating to our merger with SMART and subsequent initiatives to improve our gross margins and reduce operating expenses

 

The combined company must continue to retain, motivate and recruit executives, experts, professional staff and other key employees, which may be difficult in light of challenges of integrating the two businesses, and failure to do so could negatively affect the combined company.

 

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Our merger (the “Merger”) with SMART Business Holdings, Inc. (“SMART”) on March 10, 2010 is a significant business combination that substantially changed the size and profile of our company and also introduced a new chief executive officer to our firm. Managing change of this magnitude presents a challenge and presents risks for any business, but particularly for a professional services organization such as our company. For the merged companies to be successful, our combined company must be successful at retaining key personnel following the completion of the Merger. Since completing the Merger and announcing our integration and consolidation plans, we have had an increased level of attrition, particularly in our Economics and Dispute Resolution segment. We may continue to experience increased attrition among our experts and professional staff. Experienced experts, professional staff and executives are in high demand and competition for their talents can be intense. Employees of our combined company may experience uncertainty about their future role with the combined company until, or even after, our strategies with regard to the combined company are implemented. Our competitors are seeking to exploit that uncertainty in their efforts to recruit our experts and key employees. These potential distractions have and may continue to adversely affect our ability to retain, motivate and attract executives, experts, professional staff, and other key employees and keep them focused on our strategies and goals. A failure by our combined company to retain and motivate executives, experts, professional staff, and other key employees could have a material and adverse impact on the revenues and profitability of the combined company.

 

We may fail to realize some or all of the anticipated benefits of the Merger, which may adversely affect the value of our common stock.

 

The success of the merged companies depends, in part, on our ability to realize the anticipated benefits and cost savings from combining the historical businesses of SMART and LECG. However, to realize these anticipated benefits and cost savings, we must successfully combine these businesses. If we are not able to achieve these objectives within the anticipated time frame, or at all, the anticipated benefits and cost savings of the Merger may not be realized or may take longer to realize than expected, and the value of our common stock will be adversely affected.

 

SMART and LECG had operated independently through the completion of the Merger. The integration process has resulted, and may continue to result, in: the loss of key employees, including experts, consultants, other professionals and senior managers; and the disruption of ongoing business, or in the identification of inconsistencies in practices, controls, procedures and policies.  Any of these factors could adversely affect our ability to maintain relationships with clients, experts, professional staff, contractors, creditors, lessors, landlords, or to otherwise achieve the anticipated benefits of merging SMART and LECG.

 

Specifically, risks in integrating the operations of SMART into LECG operations in order to realize the anticipated benefits of the Merger include, among other things:

 

·                  failure of clients to accept new products or services or to continue as clients of the combined company;

 

·                  failure to successfully manage relationships with expert witnesses, consultants and other professionals, which could result in the loss of key revenue-generating professionals;

 

·                  the loss of key employees and expert staff critical to the ongoing operation of the business;

 

·                  failure to effectively coordinate sales and marketing efforts to communicate the capabilities of the combined company;

 

·                  failure to combine product and service offerings quickly and effectively;

 

·                  failure to successfully develop new products and services on a timely basis that address the market opportunities of the combined company;

 

·                  failure to compete effectively against companies already serving the broader market opportunities expected to be available to the combined company;

 

·                  unexpected revenue attrition;

 

·                  failure to successfully integrate and harmonize financial reporting and information technology systems of our combined company; and

 

·                  failure to maintain an effective internal control environment as required under the Sarbanes-Oxley Act of 2002 because as a private company, SMART was not subject to the Sarbanes-Oxley Act of 2002.

 

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Integration efforts also require effective leadership and divert management attention and resources. Our inability to realize in full the anticipated benefits of the Merger within the timeframe originally anticipated, as well as any potential further delays encountered in the integration process could have an adverse effect on our business and results of operations, and has and may further affect the value of our common stock.

 

The integration process has also resulted in the acceleration of previously anticipated integration expenses into the three months ended September 30, 2010 and the delay in the realization of the associated benefits.  Also, because integration continues, it may result in unforeseen expenses in future periods.   Actual cost synergies, if achieved at all, may be lower than we expect and may take longer to achieve than anticipated. If we are not able to adequately address these challenges, we may be unable to successfully complete the integration of SMART’s and LECG’s operations, or to realize the anticipated benefits of merging the two companies.

 

The move of our corporate headquarters has led to loss of some personnel and institutional knowledge, and may disrupt the continuity of our control functions.

 

Following the Merger, we also relocated our corporate headquarters to Devon, Pennsylvania during the three months ended September 30, 2010. The move and consolidation included our human resources, finance and accounting, information technology, conflict clearance and legal functional organizations. Key employees critical to our financial reporting and internal control environment were terminated and replaced by the end of the relocation process. The relocation has resulted in significant employee turnover. While we have experienced only nominal interruptions and loss in efficiencies as new employees gain experience in their new roles and familiarize themselves with business processes and operating requirements, the planned and unplanned loss of personnel may still lead to disruptions in control functions stemming from delays in filling vacant positions and a lack of personnel with institutional or procedural knowledge and experience.

 

The relocation has also required significant management time and effort, which was not otherwise devoted to focusing on ongoing business operations and other initiatives and opportunities. In addition, we may not realize the benefits we anticipated from the relocation, which was intended to produce cost savings and create a more unified, streamlined infrastructure. Any such difficulties or disruptions could have an adverse effect on our business, results of operations or financial condition.

 

The implementation of our restructuring activities following the Merger, which involved workforce reductions and office closures, may not successfully achieve improved long-term operating results.

 

As a result of the Merger, we identified and began pursuing opportunities for cost savings through office consolidations and workforce reductions, in order to improve operating efficiencies across our combined businesses. Part of the anticipated cost savings will result from the relocation of our corporate headquarters to Devon, Pennsylvania, which occurred during the three months ended September 30, 2010. During the nine months ended September 30, 2010, we continued with several other initiatives, including the consolidation of certain office locations, the closure of certain other offices, and a workforce reduction of administrative staff in the Emeryville office, all of which were partially offset by replacement hires in Devon, Pennsylvania.

 

During the three and nine months ended September 30, 2010, we recorded restructuring charges of $1.9 million and $9.0 million, respectively. Restructuring charges for the three months ended September 30, 2010 primarily consisted of $0.5 million of one-time termination benefits and $1.0 million of contract termination costs, while restructuring charges for the nine months ended September 30, 2010 primarily consisted of $3.7 million of one-time termination benefits and $4.2 million of contract termination costs. We do not anticipate any additional significant charges through early 2011.  Of the $9.0 million in restructuring charges recorded during the nine months ended September 30, 2010, $7.4 million required current and future cash outlays and $1.6 million was non-cash related.

 

During the three and nine months ended September 30, 2009, we recorded restructuring charges of $4.0 million and $5.5 million, respectively. Restructuring charges for the three months ended September 30, 2009 primarily consisted of $2.0 million of contract termination costs and $1.0 million of one-time termination benefits, while restructuring charges for the nine months ended September 30, 2009 primarily consisted of $2.1 million of one-time termination benefits and $2.0 million of contract termination costs.

 

As a result of these restructuring activities, our fee-generating head count was reduced, and the employment of some experts and professional staff with unique skills was terminated. In the future, other experts and employees may leave our Company voluntarily due to the uncertainties associated with our business environment, their job security or other initiatives and morale issues. In addition, we may lose revenues, miss opportunities to generate revenues or may not achieve the improved longer-term operating results that we anticipated. Any of these consequences may harm our business and our future results of operations.

 

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We have incurred and will continue to incur significant transaction and Merger-related costs associated with the Merger.

 

We have incurred and expect to continue to incur non-recurring costs associated with combining the operations of SMART and LECG. The substantial majority of non-recurring expenses resulting from the Merger include transaction costs related to the Merger, facilities and systems consolidation costs and employment-related costs, including severance and other employee separation costs. We have also incurred fees and costs related to formulating integration plans. Transaction costs incurred through September 30, 2010 totaled $6.5 million. We are still in the process of quantifying systems integration and exit activity-related costs, but this amount could ultimately total several million dollars. Additional unanticipated costs may be incurred in the integration of the two companies’ businesses in future periods. Although we expect that the elimination of duplicative costs, as well as the realization of other efficiencies related to the integration of the businesses, should allow us to offset incremental transaction and Merger-related costs over time, this net benefit may not be achieved in the near term, or at all.

 

The Merger may not be accretive and may cause dilution to our earnings per share, which may negatively affect the market price of our common stock.

 

We currently anticipate that the Merger will be accretive to earnings per share in 2011, the first full calendar year after the Merger. This expectation is based on preliminary estimates which may change materially. We could also encounter additional transaction and integration-related costs or other factors such as the failure to realize all of the benefits anticipated by merging the companies. All of these factors could cause dilution to our earnings per share or decrease or delay the expected accretive effect of the Merger and cause a decrease in the price of our common stock.

 

Various factors could adversely affect our plan to raise our gross margins and reduce our general and administrative expenses.

 

Subsequent to the quarter ended September 30, 2010, we began an initiative to raise our gross margins and to reduce our general and administrative expenses beyond the levels initially planned during the Merger.  The target of our initiative is for us to approach gross margins and general and administrative expense levels comparable to those of our publicly traded competitors.

 

There are a number of initiatives we are undertaking to improve our gross margins, including improved realization and pricing, productivity initiatives and changes in policies.  However, the most significant of these initiatives is proposed changes in the methodologies we use to compensate our experts to ensure that their compensation is better aligned with competitors in our industry and is more reflective of both the revenues they generate and the profitability associated with those revenues.  We believe the methodologies proposed are both very competitive and offer our experts other benefits.  For example, the proposed methodologies preserve the entrepreneurial nature of our firm by not limiting, or setting a ceiling on, the aggregate compensation our experts may earn.  Notwithstanding any benefits of these proposed changes, some of our experts may determine that the proposed methodologies are not suitable for their practice.  If we are unable to transition our experts to the new compensation methodology over some period of time, we may not be able to raise our gross margins.  Furthermore, if certain of our experts depart as a result of these initiatives and we are not able to recruit new experts or complete group practice acquisitions, our revenues will decline, which may adversely affect our business and results of operations.

 

The primary component of our effort to further reduce our general and administrative expenses involves identifying additional cost saving opportunities across our corporate departments, including human resources, finance and accounting, information technology, conflict clearance and legal, and operations.  We believe that better use of technology, simplification of certain back office functions, support personnel attrition and better use of our office space will help us to further reduce our general and administrative expenses as a percentage of our revenues.  However, there is no assurance that we will be able to achieve these reductions to bring general and administrative expenses in appropriate proportion to our fee levels.  If we are unable to accomplish these goals, our general and administrative expenses will remain too high as a percentage of our revenues and we may not be able to reach profitability.

 

Risks relating to our debt and our working capital requirements

 

If we are unable to make our debt service payments, or comply with the covenants and financial terms, under our term loan, our financial condition may be materially and adversely affected.

 

We have term loan debt of $30.8 million, which is due on March 31, 2011 under the terms of a term loan agreement (the “Term Loan Agreement”) and for which we must make a quarterly principal payment of $3.0 million on December 31, 2010, plus interest, and additional amounts in the event we have cash balances in excess of specified thresholds or we engage in capital raising transactions.  If we are unable to make the required payments, we may have to pay penalties, higher interest rates or repay the loan.  Each of these requirements would materially and adversely affect our financial condition.

 

The Term Loan Agreement contains various covenants, including financial covenants regarding a total funded debt to EBITDA ratio, a minimum fixed charge ratio, and minimum EBITDA and cash balance requirements.  At September 30, 2010, we were not in compliance with the EBITDA-related covenants, due to a combination of accelerated and increased integration-related expenses, the timing of realization of the related cost savings associated with these integration activities, a decrease in planned revenues driven by the continued weakness in the global economy and by expert attrition over the first half of 2010.  In addition to the steps being taken to secure refinancing of the term debt, we are currently evaluating alternatives to address the covenant non-compliance, including ongoing discussions with our current lenders to seek an amendment to reset the covenant ratios or to obtain a temporary waiver, as necessary, under our Term Loan Agreement.  The breach of the EBITDA-related covenants has resulted in a default under the Term Loan Agreement which, if not cured or waived by the lenders, permits the lenders to declare the full outstanding debt amount to be immediately due and payable, together with accrued and unpaid interest.  We would have insufficient liquidity to satisfy full repayment of the outstanding balance in a timely manner, if the remaining payments were accelerated.  Unless we are able to negotiate an amendment or waiver, we may be required to repay all amounts then outstanding, which could have a material adverse effect on our business, results of operations and financial condition.  Even without acceleration, the loan is due on March 31, 2011.  See the “Liquidity and Capital Resources” section of this Quarterly Report for further information on our term debt and our efforts to secure a new revolving credit facility.

 

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Certain other terms of our term loan restrict our ability to conduct our business, which could have an adverse impact on our operations.

 

Our indebtedness limits our ability to borrow additional funds and requires us to dedicate a substantial portion of our cash flow from operations to service the debt, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate expenditures.  This, in turn: (1) increases our vulnerability to adverse general economic or industry conditions and to increases in interest rates; (2) limits our flexibility in planning for, or reacting to, changes in our business or our industry; (3) limits our ability to make strategic acquisitions and investments, introduce new services, enter new markets, or exploit business opportunities; and (4) places us at a competitive disadvantage relative to competitors that have less debt or greater financial resources.

 

If we fail to make any of the quarterly or other required payments, we fail to cure, amend or obtain a waiver of the financial or operating covenants, or we are unable to repay the loan when due, we would be in default and it could have an adverse effect on our business, results of operations or financial condition.  If we are unable to obtain a waiver or amendment of certain financial tests under our loan agreement, the lenders could cause all amounts outstanding to be due and payable immediately. Our assets or cash flow will not be sufficient to fully repay our indebtedness if accelerated upon an event of default, and there is no guarantee that we would be able to repay, refinance or restructure the payment obligations.

 

We are currently seeking to refinance this indebtedness. In the event we are required to refinance our credit facility in unfavorable market conditions, we may have to pay interest at higher rates on outstanding borrowings and may be subject to more stringent financial covenants than we are today, which could adversely affect our results of operations. We cannot be certain that we will be able to obtain refinancing on acceptable terms.

 

We no longer have a revolving credit facility to provide us with flexible access to working capital to operate our business, and we cannot be certain of our access to additional capital if needed.

 

Historically, we have relied upon a revolving credit facility to provide us with adequate working capital to operate our business. In connection with our Merger, we were required to repay the outstanding balance under our revolving credit facility and to terminate that facility. As a result, we no longer have access to that facility as a flexible source of working capital. Although our cash balances increased directly after the Merger and the related investment, the balances have been depleted by the Merger-related integration expenses, weakness in the global economy and by expert attrition.  As a result, we may not have sufficient capital to fund our operating needs and/or we may need to secure additional financing to fund our working capital requirements or to repay outstanding debt. We cannot be certain that we will be able to raise additional capital, or that any amount, if raised, will be sufficient to meet our cash requirements. Also, if we are not able to borrow or otherwise raise additional capital when needed, we may be forced to curtail our operations.

 

Risks relating to our expert and professional services businesses

 

We are dependent on retaining our experts to keep our existing clients and ongoing and future projects, and our financial results and growth prospects could suffer if we are unable to successfully attract and retain our experts and professional staff.

 

Many of our clients are attracted to us by their desire to engage individual experts, and the ongoing relationship with our clients is often managed primarily by our individual experts. If an expert terminates his or her relationship with us, it is probable that most of the clients and projects for which that expert is responsible will continue with the expert, and the clients will terminate or significantly reduce their relationship with us. Since completing the Merger, and announcing our integration and consolidation plans, we have had an increased level of attrition. We may continue to experience increased attrition among our experts and professional staff. We generally do not have non-competition agreements with any of our experts, unless the expert came to us through an acquisition of a business. Consequently, experts can generally terminate their relationship with us at any time and immediately begin to compete against us. Our top five experts accounted for 13% and 11% of our revenues during the nine months ended September 30, 2010 and 2009, respectively. If any of these individuals, or our other experts, terminate their relationship with us or compete against us, it could materially harm our business and financial results.

 

In addition, if we are unable to attract, develop, and retain highly qualified experts, professional staff and administrative personnel, our ability to adequately manage and staff our existing projects and obtain new projects could be impaired, which would adversely affect our business, our financial results and our prospects for growth. Qualified professionals are in great demand, and we face significant competition for both experts and professional staff with the requisite credentials and experience. Our competition comes from other consulting firms, research firms, governments, universities and other similar enterprises. Many of these competitors may be able to offer greater compensation and benefits or more attractive lifestyle choices, career paths or geographic locations than we do. Increasing competition for these professionals may also significantly increase our labor costs, which could negatively affect our margins and results of operations. The loss of services from, or the failure to recruit, a significant number of experts, professional staff or administrative personnel could harm our business, including our ability to secure and complete new projects.

 

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Our financial results could suffer if we are unable to achieve or maintain high utilization and billing rates for our professional staff.

 

Our profitability depends to a large extent on the utilization of our professional staff and the billing rates we are able to charge for their services. Utilization of our professional staff is affected by a number of factors, including:

 

·                  the number and size of client engagements;

 

·                  our experts’ use of professional staff to perform the projects they obtain from clients and the nature of specific client engagements, some of which require greater professional staff involvement than others;

 

·                  the timing of the commencement, completion and termination of projects, which in many cases is unpredictable;

 

·                  our ability to transition our professional staff efficiently from completed projects to new engagements;

 

·                  our ability to forecast demand for our services and thereby maintain an appropriate level of professional staff; and

 

·                  conditions affecting the industries in which we practice as well as general economic conditions.

 

The billing rates of our professional staff that we are able to charge are also affected by a number of additional factors, including:

 

·                  the quality of our expert and professional services;

 

·                  the market demand for the expert services we provide;

 

·                  our competition and the pricing policies of our competitors; and

 

·                  general economic conditions.

 

Forecasting demand for our services and managing staffing levels and transitions in the face of the uncertainties in engagement demand is quite difficult, especially during the current U.S. and European economic slow-down. If we are unable to achieve and maintain high utilization as well as maintain or increase the billing rates for our billable professional staff, our financial results could suffer materially.

 

Our Sarbanes-Oxley compliance business may decline.

 

The demand for services related to Sarbanes-Oxley or other regulatory compliance, which was conducted by SMART before SMART merged with LECG, has declined over the last year and may decline further. A key component of this business includes services related to Sarbanes-Oxley and other regulatory compliance. There can be no assurance that there will be ongoing demand for these services.

 

A reversal of or decline in the current trend of businesses utilizing third-party service providers may have a material adverse effect on our business.

 

The part of our business historically conducted by SMART and its growth depends in part on the trend toward businesses utilizing third-party service providers. This trend may not continue. Current and potential customers may elect to perform such services with their own employees. A significant reversal of, or a decline in, this trend would have a material adverse effect on our financial condition and results of operations.

 

Our client projects may be terminated or initiated suddenly, which may negatively impact our financial results.

 

Our projects generally center on decisions, disputes, proceedings or transactions in which clients are seeking expert advice, opinion or service. Our projects can terminate suddenly and without advance notice to us. Our clients may decide at any time to settle their disputes or proceedings, to abandon or defer their transactions or to take other actions that result in the early termination of a project. Our clients are ordinarily under no contractual obligation to continue using our services. If an engagement is terminated unexpectedly, or even upon the planned completion of a project, our professionals working on that engagement may be underutilized

 

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until we assign and transition them to other projects. The termination, deferral or significant reduction in the scope of a single large engagement could negatively impact our results of operations in a given reporting period.

 

Conversely, projects may be initiated or expanded suddenly, and we may not be able to adequately manage the demands placed upon our experts and staff when that occurs. This could result in inefficiencies and additional time spent on engagements by our experts and staff that we may not be able to bill and collect. For example, in 2006 and 2007 we experienced a significant increase in work performed that we considered uncollectible, a part of which was the result of our failure to successfully manage certain engagements. If we are unable to successfully manage the requirements and time spent by experts and staff on engagements, our financial results may be adversely impacted.

 

Our ability to maintain and attract new business depends upon our reputation, the professional reputation of our experts and the quality of our services on client projects.

 

Our ability to secure new projects depends heavily upon our reputation and the individual reputations of our experts and professional staff. Any factor that diminishes our reputation or that of our experts and professional staff could make it substantially more difficult for us to attract new projects and clients. Similarly, because we obtain many of our new projects from clients that we have worked with in the past or from referrals by those clients, any client that is dissatisfied with the quality of our work or that of our experts and professional staff could seriously impair our ability to secure additional new projects and clients.

 

In litigation, we believe that there has been an increase in the frequency of challenges made by opposing parties to the qualifications of experts. In the event a court or other decision-maker determines that an expert is not qualified to serve as an expert witness in a particular matter, then this determination could harm the expert’s reputation and ability to act as an expert in other engagements which could in turn harm our business reputation and our ability to obtain new engagements.

 

We depend on complex damages and competition policy/antitrust practices, which could be adversely affected by changes in the legal, regulatory and economic environment.

 

Our expert services business is heavily concentrated in the practice areas of complex damages and competition policy/antitrust, including mergers and acquisitions. Projects in our complex damages practice area account for 28% and 27% of our billings in the nine months ended September 30, 2010 and 2009, respectively. Projects in our global competition practice area, including mergers and acquisitions, accounted for 16% of our billings in the nine months ended September 30, 2010 and 2009. Changes in the federal antitrust laws or the federal regulatory environment, or changes in judicial interpretations of these laws could substantially reduce the need for expert consulting services in these areas. This would reduce our revenues and the number of future projects in these practice areas. In addition, adverse changes in general economic conditions, particularly conditions influencing the merger and acquisition activity of larger companies, could also negatively impact the number and scope of our projects in proceedings before the Department of Justice and the Federal Trade Commission.

 

Intense competition from economic, business and financial consulting firms could hurt our business.

 

The market for expert consulting and professional advisory services is intensely competitive, highly fragmented and subject to rapid change. Many of our competitors are national and international in scope and have significantly greater personnel, financial, technical and marketing resources. We may be unable to compete successfully with our existing competitors or with any new competitors. There are relatively low barriers to entry, and we have faced and expect to continue to face additional competition from new entrants into the economic, business and financial consulting industries. In the litigation and regulatory expert services markets, we compete primarily with economic, business and financial consulting firms and individual academics. Expert services are also available from a variety of participants in the business consulting market, including general management consulting firms, the consulting practices of major accounting firms, technical and economic advisory firms, regional and specialty consulting firms, small consulting companies and the internal professional resources of companies.

 

Conflicts of interest could preclude us from accepting projects.

 

We provide our expert services primarily in connection with significant or complex decisions, disputes and regulatory proceedings that are often adversarial or involve sensitive client information. Our engagement by a given client may preclude us from accepting projects with that client’s competitors or adversaries because of conflicts of interest or other business reasons. As we increase the diversity of our service offerings and the size of our operations, the number of conflict situations can be expected to increase. Moreover, in many industries in which we provide services, for example the petroleum and telecommunications industries, there has been a continuing trend toward business consolidations and strategic alliances, the impact of which is to reduce the number of companies that may seek our services and to increase the chances that we will be unable to accept new projects as a result of conflicts of interest. If we are unable to accept new assignments for any reason, our business may not grow and our professional staff may become underutilized, which would adversely affect our revenues and results of operations in future periods.

 

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Our engagements could result in professional liability, which could be very costly and hurt our reputation.

 

Our projects typically involve complex analysis and the exercise of professional judgment. As a result, we are subject to the risk of professional liability. Many of our projects involve matters that could have a severe impact on a client’s business, cause a client to gain or lose significant amounts of money or assist or prevent a client from pursuing desirable business opportunities. If a client questions the quality of our work, the client could threaten or bring a lawsuit to recover damages or contest its obligation to pay our fees. Litigation alleging that we performed negligently or breached any other obligations to a client could expose us to significant liabilities and damage our reputation. We carry professional liability insurance intended to cover many of these types of claims, but the policy limits and the breadth of coverage may be inadequate to cover any particular claim or all claims plus the cost of legal defense. For example, we provide services on engagements in which the amounts in controversy or the impact on a client may substantially exceed the limits of our errors and omissions insurance coverage. If we are found to have professional liability with respect to work performed on such an engagement, we may not have sufficient insurance to cover the entire liability. Defending ourselves in any litigation, regardless of the outcome, is often very costly, could result in distractions to our management and experts and could harm our business and our reputation.

 

Other risks relating to our business

 

Recent turmoil in the credit markets and in the financial services industry may impact our ability to collect receivables on a timely basis and may negatively impact our cash flow.

 

Recently, the credit markets and the financial services industry have been experiencing a period of unprecedented turmoil and upheaval. While the ultimate outcome of these events cannot be predicted, they could adversely impact the availability of financing and working capital to our clients and therefore adversely impact our ability to collect amounts due from such clients or cause them to terminate their contracts with us completely.

 

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Our estimated restructuring accruals may not be adequate.

 

While our management uses all available information to estimate restructuring charges, particularly facilities costs, our estimated accruals for restructuring may prove to be inadequate. If our actual sublease revenues or the results of our exiting negotiations differ from our assumptions, we may have to record additional charges, which could materially affect our results of operations, financial position and cash flow.

 

Impairment charges could reduce our results of operations.

 

In accordance with the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 350, Goodwill and Other Intangible Assets (“ASC 350”), we test goodwill and other intangible assets with indefinite lives for impairment at least annually, or whenever events or changes in circumstances indicate that the carrying amounts of these assets may not be recoverable. As a result of the Merger, we recently added goodwill and other intangible assets within our condensed consolidated balance sheet, attributed to our Consulting and Governance segment. We tested our goodwill for impairment as of October 1, 2010, except for the goodwill recorded as a result of the Merger and the Bourne acquisition, and, as a result of that testing, recorded a goodwill impairment charge of $1.8 million during each of the three and nine months ended September 30, 2010 related to our March 2007 acquisition of The Secura Group, LLC. As both the Merger and the Bourne acquisition occurred in 2010, we scheduled our testing of the goodwill recorded as a result of the Merger and the Bourne acquisition for December 1, 2010.

 

Various uncertainties, including changes in business trends, deterioration in the political environment, continued adverse conditions in the capital markets or changes in general economic conditions, could impact the expected cash flows to be generated by an intangible asset or group of intangible assets, and may result in an impairment of those assets. Although any impairment charge would be a non-cash expense, further impairment of our intangible assets could materially increase our expenses and reduce our results of operations.

 

Changes in our effective tax rate may harm our results of operations.

 

A number of factors may increase our future effective tax rates, including:

 

·                  the jurisdictions in which profits are determined to be earned and taxed;

 

·                  the resolution of issues arising from tax audits with various tax authorities;

 

·                  changes in the valuation of our deferred tax assets and liabilities;

 

·                  adjustments to estimated taxes upon finalization of various tax returns;

 

·                  increases in expenses not deductible for tax purposes, including impairments of goodwill;

 

·                  changes in available tax credits or limitations on our ability to utilize foreign tax credits;

 

·                  changes in share-based compensation;

 

·                  changes in tax laws or the interpretation of such tax laws, and changes in generally accepted accounting principles; and

 

·                  the repatriation of non-U.S. earnings for which we have not previously provided for U.S. taxes.

 

Any significant change in our future effective tax rates could reduce net income or negatively impact earnings for future periods.

 

Additional hiring and acquisitions could disrupt our operations, increase our costs or otherwise harm our business.

 

A portion of our business strategy is dependent in part upon our ability to grow by hiring individuals or groups of experts and by acquiring other expert services firms. However, we may be unable to identify, hire, acquire or successfully integrate new experts and consulting practices without substantial expense, delay or other operational or financial problems. And, we may be unable to achieve the financial, operational and other benefits we anticipate from any hiring or acquisition. Hiring additional experts or acquiring other expert services firms could also involve a number of additional risks, including:

 

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·                  the diversion of management’s and key senior experts’ time, attention and resources, especially since key senior experts involved in the recruiting and acquisition process also provide consulting services that account for a significant amount of our revenues;

 

·                  loss of key acquisition-related personnel;

 

·                  the incurrence of significant signing and performance bonuses, which could adversely impact our profitability and cash flow, or result in the later write-off of unearned portions of such bonuses, which could adversely impact our profitability;

 

·                  additional expenses associated with the amortization, impairment or write-off of acquired intangible assets, which could adversely impact our profitability;

 

·                  potential assumption of debt to acquire businesses;

 

·                  potential impairment of existing relationships with our experts, professionals and clients;

 

·                  the creation of conflicts of interest that require us to decline engagements that we otherwise could have accepted;

 

·                  increased costs to improve, coordinate or integrate managerial, operational, financial and administrative systems;

 

·                  increased costs associated with the opening and build-out of new offices, redundant offices in the same city where consolidation is not immediately possible or office closures where consolidation is possible, which would result in the immediate recognition of expense associated with the abandoned lease;

 

·                  dilution to our stockholders as a result of issuing equity securities in connection with hiring new experts or acquiring other expert services firms; and

 

·                  difficulties in integrating diverse corporate cultures.

 

We are subject to additional risks associated with international operations.

 

We currently have operations in Argentina, Belgium, China, France, Hong Kong, Italy, Spain and the United Kingdom. Revenues attributable to activities outside of the United States were 19.3% and 18.3% for the nine months ended September 30, 2010 and 2009, respectively. Foreign tax laws can be complex and disputes with foreign tax authorities can be lengthy and span multiple years. We have been involved in a tax dispute with the Argentine tax authority since 2007 regarding a potential income tax deficiency related to our 2003 and 2004 tax returns and a withholding tax deficiency in connection with our 2005 withholding tax return totaling $3.3 million, which includes potential interest if our position is not ultimately sustained. We paid this amount and filed an appeal with the tax authorities, objecting to their position and requesting a refund. On April 8, 2009, we were notified that the AFIP had terminated the penalty procedures relating to amounts previously paid for the 2003 and 2004 income tax and 2005 withholding tax deficiencies due to the passage of Argentine National Law No. 26.476 (Tax Moratorium). However, we may still be subject to penalties and interest on a potential underpayment of taxes related to the 2005 withholding tax return. Also, based on the results of the completed audit discussed above, we may receive additional notices for assessments of additional income taxes, penalties, and interest related to our 2005 and 2006 income tax returns and withholding taxes, and penalties for payments made to the U.S. parent company to settle intercompany balances from June 2005 to December 2007. On September 9, 2010, LECG BA-LECG LLC filed the refund claim with the National Tax Court due to the omission of the AFIP to decide the refund claim submitted by us in June 2008. On September 16, 2010, LECG BA was served notice of the denial by the AFIP of the refund claim filed in June 2008 (Resolución 122/2010). The denial was based on the formal objection to the evidence (documentation) presented by us, but the AFIP did not analyze the legal/tax arguments on which we based the refund claim. On October 7, 2010, we filed an appeal to Resolución 122/2010 with the National Tax Court.  In our opinion, none of these recent developments will have a financial statement impact as they are only administrative in nature and do not have any effect on the validity of our position in these matters.

 

We may continue to expand internationally and our international revenues may account for an increasing portion of our revenues in the future. In addition to the tax dispute noted above, our international operations carry special financial and business risks, including:

 

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·                  greater difficulties in managing and staffing foreign operations;

 

·                  less stable political and economic environments;

 

·                  cultural differences that adversely affect utilization;

 

·                  currency fluctuations that adversely affect our financial position and operating results;

 

·                  unexpected changes in regulatory requirements, tariffs and other barriers;

 

·                  civil disturbances or other catastrophic events that reduce business activity; and

 

·                  greater difficulties in collecting accounts receivable.

 

The occurrence of any one of these factors could have an adverse effect on our operating results.

 

Risks Related to investing in our stock.

 

Because the Great Hill Entities hold a significant interest in our voting stock following the closing of the Merger, the influence of our other public stockholders over the election of directors and significant corporate actions may be more limited than it would be if there were no stockholder owning such a significant percentage of our outstanding voting stock.

 

Great Hill Equity Partners III, LP and Great Hill Investors, LLC (together, the “Great Hill Entities”) own a significant portion of our outstanding voting stock and have designated two of the members of our board of directors. Although an agreement imposes limits on the Great Hill Entities regarding taking specified actions related to the acquisition of additional shares of our capital stock and the removal of directors, the Great Hill Entities will nonetheless still be able to exert significant influence over the outcome of a range of corporate matters, including significant corporate transactions requiring a stockholder vote, such as a merger or a sale of the combined company or its assets. This concentration of ownership and influence in management and board decision-making could also harm the price of our common stock in the future by, among other things, discouraging a potential acquirer from seeking to acquire shares of our common stock (whether by making a tender offer or otherwise) or otherwise attempting to obtain control of the combined company.

 

Sales of our common stock by the Great Hill Entities or issuances of shares of our common stock in connection with future acquisitions or otherwise could cause the price of our common stock to decline.

 

If the Great Hill Entities sell a substantial number of their shares of our common stock in the future, the market price of our common stock could decline. The perception among investors that these sales may occur could produce the same effect. The Great Hill Entities have rights, subject to specified conditions, to require us to file registration statements covering shares of common stock held by them or to include shares of common stock held by them in registration statements that we may file. By exercising their registration rights and selling a large number of shares of our common stock, the Great Hill Entities could cause the price of our common stock to decline. Furthermore, if we were to include common stock held by the Great Hill Entities in a registration statement we initiate, those additional shares could impair our ability to raise needed capital by depressing the price at which we could sell our common stock.

 

One component of our business strategy is to make acquisitions. In the event of any future acquisitions, we could issue additional shares of common stock, which would have the effect of diluting existing stockholders’ percentage ownership of our common stock and could cause the price of our common stock to decline.

 

Our Merger and the investment by the Great Hill Entities were dilutive to our existing stockholders.

 

As a result of our Merger and the related investment, we issued 17.2 million new shares of capital stock to the Great Hill Entities, which now represents a significant portion of the total outstanding voting power of all of our stockholders. The issuance of these shares caused immediate and significant dilution to existing stockholders. An additional 1.1 million new shares of our common stock may also be issued to Great Hill III to satisfy certain indemnification obligations described in the Merger Agreement, and we have agreed to grant the Great Hill Entities pre-emptive rights for certain future new issuances of our capital stock. Further, the holders of our Series A Convertible Redeemable Preferred Stock are entitled to receive cumulative dividends at a rate of 7.5% per share per annum or, subject to increase in some circumstances, which may be paid in cash or additional shares of our capital stock. The dividends, if paid in stock, will further dilute our current stockholders.

 

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The market price of our common stock after our Merger has been and may be affected by factors different from those affecting our shares prior to the Merger.

 

The historic businesses of our combined company differ in important respects and, accordingly, the results of operations of the combined company and the market price of our common stock following the Merger has been and may continue to be affected by factors different from those previously affecting the independent results of operations of LECG and SMART.

 

Our stock price has been and may continue to be volatile.

 

The price of our common stock has fluctuated widely.  For example, from September 30, 2009 through October 31, 2010, the per share price of our stock has fluctuated from a high of $3.66 to a low of $0.86. The price of our common stock may continue to fluctuate, depending upon many factors, including but not limited to the risk factors listed above and the following:

 

·                  the limited trading volume of our common stock on the NASDAQ Global Select Market;

 

·                  variations in our quarterly results of operations;

 

·                  the hiring or departure of key personnel, including experts;

 

·                  our ability to maintain high utilization of our professional staff;

 

·                  announcements by us or our competitors;

 

·                  the loss of significant clients;

 

·                  changes in our reputation or the reputations of our experts;

 

·                  acquisitions or strategic alliances involving us or our competitors;

 

·                  changes in the legal and regulatory environment affecting businesses to which we provide services;

 

·                  changes in estimates of our performance or recommendations by securities analysts;

 

·                  inability to meet quarterly or yearly estimates or targets of our performance; and

 

·                  market conditions in the industry and the economy as a whole.

 

If the trading price of our common stock remains below $1.00, our common stock could be delisted from the NASDAQ Global Select Market.

 

We must meet NASDAQ’s continuing listing requirements in order for our common stock to remain listed on the NASDAQ Global Select Market.  The listing criteria we must meet include, but are not limited to, a minimum bid price for our common stock of $1.00 per share.  The recent trading price of our common stock has fallen below that level, and has traded as low as $0.84 per share subsequent to the three months ended September 30, 2010.  Failure to meet NASDAQ’s continued listing criteria may result in the delisting of our common stock from the NASDAQ Global Select Market. A delisting from the NASDAQ Global Select Market will make the trading market for our common stock less liquid, and will also make us ineligible to use Form S-3 to register the sale of shares of our common stock or to register the resale of our securities held by certain of our security holders with the SEC, thereby making it more difficult and expensive for us to register our common stock or other securities and raise additional capital.

 

The issuance of preferred stock could discourage or prevent an acquisition of our company, even if the acquisition would be beneficial to our stockholders.

 

Our board of directors has the authority to issue preferred stock and to determine the preferences, limitations and relative rights of shares of preferred stock and to fix the number of shares constituting any series and the designation of such series, without any further vote or action by our stockholders. The preferred stock could be issued with voting, liquidation, dividend and other rights superior to the rights of our common stock. The potential issuance of preferred stock may make it more difficult for a person to acquire a majority of our outstanding voting stock, and thereby delay or prevent a change in control of our Company, discourage bids for our common stock over the market price and adversely affect the market price and the relative voting and other rights of the holders of our common stock.

 

Our charter documents and Delaware law could prevent a takeover that stockholders consider favorable and could also reduce the market price of our stock.

 

Our amended and restated certificate of incorporation and our bylaws contain provisions that could delay or prevent a change in control of our Company. For example, our charter documents prohibit stockholder actions by written consent.

 

In addition, the provisions of Section 203 of Delaware General Corporate Law govern us. These provisions may prohibit large stockholders, in particular those owning 15% or more of our outstanding voting stock, from merging or combining with us. These and other provisions in our amended and restated certificate of incorporation, our bylaws and under Delaware law could reduce

 

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the price that investors might be willing to pay for shares of our common stock in the future and result in the market price being lower than it would be without these provisions.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

None.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4. (REMOVED AND RESERVED)

 

None.

 

ITEM 5. OTHER INFORMATION

 

None.

 

ITEM 6. EXHIBITS

 

Exhibit
No.

 

Description

 

SEC Reference Document

 

 

 

 

 

2.1

 

Agreement and Plan of Merger, dated August 17, 2009, by and among LECG Corporation, Red Sox Acquisition Corporation, Red Sox Acquisition LLC, Smart Business Holdings, Inc. and, solely for purposes of articles 2A, 5 and 7 and Section 4.20, Great Hill Equity Partners III, LP

 

Incorporated by reference to Exhibit 2.1 to Current Report on Form 8-K filed on August 21, 2009

 

 

 

 

 

2.2

 

Amendment No. 1, dated September 25, 2009, to the Agreement and Plan of Merger dated August 17, 2009

 

Incorporated by reference to Exhibit AA to Definitive Proxy Statement on Schedule 14A filed on November 18, 2009

 

 

 

 

 

2.3

 

Amendment No. 2, dated February 16, 2010, to the Agreement and Plan of Merger dated August 17, 2009

 

Incorporated by reference to Exhibit 2.2 to Current Report on Form 8-K filed on February 16, 2010

 

 

 

 

 

2.4

 

Business Sale Agreement, dated June 22, 2010, by and among LECG Limited, LECG Corporation, Bourne Business Consulting LLP, Bourne Business Consulting Limited, and the Partners

 

Incorporated by reference to Exhibit 2.4 to Quarterly Report on Form 10-Q filed on August 9, 2010

 

 

 

 

 

3.1

 

Second Amended and Restated Certificate of Incorporation of LECG Corporation as filed with the Secretary of State of Delaware on March 10, 2010

 

Incorporated by reference to Exhibit 3.5 to Current Report on Form 8-K filed on March 16, 2010

 

 

 

 

 

3.2

 

Certificate of Designations of Series A Convertible Redeemable Preferred Stock of LECG Corporation as filed with the Secretary of State of Delaware on March 10, 2010

 

Incorporated by reference to Exhibit 3.6 to Current Report on Form 8-K filed on March 16, 2010

 

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3.3

 

Bylaws of LECG Corporation

 

Incorporated by reference to Exhibit 3.2 to Registration Statement on Form S-1 (Amendment 1) filed on October 1, 2003

 

 

 

 

 

3.4

 

Amendments to Bylaw of LECG Corporation

 

Incorporated by reference to Exhibit 99.3 to Current Report on Form 8-K filed on August 21, 2009

 

 

 

 

 

10.1

 

Second Amended and Restated Credit Agreement, dated as of December 15, 2006, by and among LECG, LLC, as Borrower, the several banks and other financial institutions parties thereto, LaSalle Bank National Association and Banc of America Securities, LLC, as co-Lead Arrangers and Book Runners, LaSalle Bank National Association as Administrative Agent, Bank of America, N.A., as Syndication Agent and Keybank National Association, U.S. Bank National Association and Wells Fargo Bank, N.A., as co-Lead Documentation Agents.

 

NOTE: Exhibit refiled with this Quarterly Report to include schedules, which were omitted when this Exhibit was initially filed as Exhibit 10.64 to Current Report on Form 8-K on December 20, 2006

 

 

 

 

 

31.1

 

Certification pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002 for principal executive officer

 

 

 

 

 

 

 

31.2

 

Certification pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002 for principal financial officer

 

 

 

 

 

 

 

32.1

 

Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

LECG CORPORATION

 

(Registrant)

 

 

Date: November 9, 2010

/s/ Steve Samek

 

Chief Executive Officer

 

(Principal Executive Officer)

 

 

Date: November 9, 2010

/s/ Warren Barratt

 

Chief Financial Officer

 

(Principal Financial Officer)

 

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Exhibit Index

 

Exhibit
No.

 

Description

 

SEC Reference Document

 

 

 

 

 

2.1

 

Agreement and Plan of Merger, dated August 17, 2009, by and among LECG Corporation, Red Sox Acquisition Corporation, Red Sox Acquisition LLC, Smart Business Holdings, Inc. and, solely for purposes of articles 2A, 5 and 7 and Section 4.20, Great Hill Equity Partners III, LP

 

Incorporated by reference to Exhibit 2.1 to Current Report on Form 8-K filed on August 21, 2009

 

 

 

 

 

2.2

 

Amendment No. 1, dated September 25, 2009, to the Agreement and Plan of Merger dated August 17, 2009

 

Incorporated by reference to Exhibit AA to Definitive Proxy Statement on Schedule 14A filed on November 18, 2009

 

 

 

 

 

2.3

 

Amendment No. 2, dated February 16, 2010, to the Agreement and Plan of Merger dated August 17, 2009

 

Incorporated by reference to Exhibit 2.2 to Current Report on Form 8-K filed on February 16, 2010

 

 

 

 

 

2.4

 

Business Sale Agreement, dated June 22, 2010, by and among LECG Limited, LECG Corporation, Bourne Business Consulting LLP, Bourne Business Consulting Limited, and the Partners

 

Incorporated by reference to Exhibit 2.4 to Quarterly Report on Form 10-Q filed on August 9, 2010

 

 

 

 

 

3.1

 

Second Amended and Restated Certificate of Incorporation of LECG Corporation as filed with the Secretary of State of Delaware on March 10, 2010

 

Incorporated by reference to Exhibit 3.5 to Current Report on Form 8-K filed on March 16, 2010

 

 

 

 

 

3.2

 

Certificate of Designations of Series A Convertible Redeemable Preferred Stock of LECG Corporation as filed with the Secretary of State of Delaware on March 10, 2010

 

Incorporated by reference to Exhibit 3.6 to Current Report on Form 8-K filed on March 16, 2010

 

 

 

 

 

3.3

 

Bylaws of LECG Corporation

 

Incorporated by reference to Exhibit 3.2 to Registration Statement on Form S-1 (Amendment 1) filed on October 1, 2003

 

 

 

 

 

3.4

 

Amendments to Bylaw of LECG Corporation

 

Incorporated by reference to Exhibit 99.3 to Current Report on Form 8-K filed on August 21, 2009

 

 

 

 

 

10.1

 

Second Amended and Restated Credit Agreement, dated as of December 15, 2006, by and among LECG, LLC, as Borrower, the several banks and other financial institutions parties thereto, LaSalle Bank National Association and Banc of America Securities, LLC, as co-Lead Arrangers and Book Runners, LaSalle Bank National Association as Administrative Agent, Bank of America, N.A., as Syndication Agent and Keybank National Association, U.S. Bank National Association and Wells Fargo Bank, N.A., as co-Lead Documentation Agents.

 

NOTE: Exhibit refiled with this Quarterly Report to include schedules, which were omitted when this Exhibit was initially filed as Exhibit 10.64 to Current Report on Form 8-K on December 20, 2006

 

 

 

 

 

31.1

 

Certification pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002 for principal executive officer

 

 

 

 

 

 

 

31.2

 

Certification pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002 for principal financial officer

 

 

 

 

 

 

 

32.1

 

Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

 

 

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