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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q/A

(Amendment No. 1)

 

 

 

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

For the quarterly period ended March 31, 2012

OR

 

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

For the transition period from                      to                     

Commission file number: 333-177233-19 and 000-50280

 

 

 

LOGO

iPayment Holdings, Inc.

iPayment, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware

Delaware

 

20-4777880

62-1847043

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

126 East 56th Street, 33rd Floor

New York, New York

  10022
(Address of principal executive offices)   (Zip Code)

Registrants’ telephone number, including area code: (212) 802-7200

 

 

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.

 

iPayment Holdings, Inc.    Yes  ¨    No  x
iPayment, Inc.    Yes  ¨    No  x

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).

 

iPayment Holdings, Inc.    Yes  ¨    No  x
iPayment, Inc.    Yes  ¨    No  x

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.

 

iPayment Holdings, Inc.   Large accelerated filer  ¨    Accelerated filer  ¨   Non-accelerated filer  x   Smaller reporting company  ¨
iPayment, Inc.   Large accelerated filer  ¨    Accelerated filer  ¨   Non-accelerated filer  x   Smaller reporting company  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

iPayment Holdings, Inc.

   Yes  ¨    No  x

iPayment, Inc.

   Yes  ¨    No  x

 

Title of each class    Shares Outstanding at May 11, 2012

iPayment Holdings, Inc. (Common stock, $0.01 par value)

   4,875,000

iPayment, Inc. (Common stock, $0.01 par value)

   100

 

 

 


Table of Contents

Explanatory Note

iPayment, Inc. (the “Company”) and iPayment Holdings, Inc. (“Holdings”) are filing this Amendment No. 1 to Quarterly Report on Form 10-Q/A (the “Amended Filing”) to our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2012, originally filed with the Securities and Exchange Commission (the “SEC”) on May 11, 2012 (the “Original Filing”), to amend and restate our unaudited financial statements and related disclosures for the quarters ended March 31, 2011 and 2012 and amend certain other Items in the Original Filing as listed in “Items Amended in this Filing” below, as a result of the restatement of our financial statements. The details of the restatement are discussed below and in Note 2 to the accompanying restated consolidated financial statements.

Background of Restatement

In August 2012, as disclosed in the Company’s Current Reports on Form 8-K filed on September 12, 2012 and November 5, 2012 the Company and Holdings were presented with accusations from one of the Company’s employees that certain of the Company’s employees and outside contractors had engaged in financial misconduct. Following an initial inquiry into these accusations by the Company, the Board of Directors of the Company engaged Debevoise & Plimpton LLP and forensic accountants of Ernst & Young LLP to work with management to conduct an internal investigation of the alleged misconduct. During the course of the Company’s investigation, certain executives of the Company and Holdings were terminated or resigned.

The Company’s internal investigation revealed financial misconduct by certain former officers and employees of the Company and certain of its outside contractors. Such misconduct occurred in five principal areas: (i) failure to maintain an adequate control environment that set a proper culture within our operations; (ii) creation of false obligations to make residual and other payments (which resulted in the Company making such payments in respect of merchant accounts that were not subject to legitimate payment obligations); (iii) overstatement of certain vendor invoices, principally in the information technology area; (iv) falsification of certain employee expense reimbursements and other payments; and (v) the posting of manual journal entries without sufficient supporting documentation or adequate review and approval. The adjustments related to the financial misconduct and the recording of other prior period adjustments not related to the financial misconduct are set forth in the table below.

 

     Cumulative
embezzlement costs

through March 31,
2012
     iPayment Holdings, Inc. &
iPayment, Inc. (Successor)
    Cumulative
embezzlement
costs through

December 31,
2011
 

(Dollars in thousands)

      Three Months Ended
March 31, 2012
   

Embezzlement costs

       

Residual expense

   $ 4,099       $ 427      $ 3,672   

Property and equipment

     2,149         207        1,942   

Other intangible assets

     1,970         288        1,682   

Residual buyout

     1,625         —          1,625   

Travel and entertainment

     229         —          229   

Prepaids and other receivables

     208         —          208   

Other

     123         —          123   
  

 

 

    

 

 

   

 

 

 

Total embezzlement costs

   $ 10,403         922      $ 9,481   
  

 

 

      

 

 

 

Embezzlement costs previously included in the statements of operations as:

       

Other costs of services

        (647  

Prior period adjustments not related to fraudulent transactions

  

    

Reversal of residual buyout amortization adjustment

        1,996     

Reversal of deferred gain amortization

        230     

Tax adjustments

  

    

Tax effect of the above recorded adjustments

        (134  

Prior period tax adjustments not related to fraudulent transactions

        1,473     
     

 

 

   

Net decrease

  

     3,840     

Net loss, as previously reported (1)

  

     (5,925  
     

 

 

   

Net loss, as restated (1)

  

   $ (9,765  
     

 

 

   

(1) For 2012, net loss is for iPayment Holdings, Inc.

Total embezzlement costs incurred by the Company cumulatively through March 31, 2012 were $10.4 million. $0.9 million of such identified losses were incurred during the three months ended March 31, 2012. $0.6 million of the identified losses for the three months ended March 31, 2012 were classified as residual and other expenses within other costs of services in the consolidated financial statements during the period in which the misconduct took place. The Company reclassified these costs as embezzlement costs included in total operating expenses. These reclassified embezzlement costs had no effect on the Company’s income from operations and net income (loss) in its previously issued March 31, 2012 quarterly financial statements.


Table of Contents

The remaining amount of such identified embezzlement costs totaling $0.3 million for the three months ended March 31, 2012 was capitalized in the financial statements as property and equipment or other intangible assets during the period in which the misconduct took place. Such losses were written off as embezzlement costs in the restated March 31, 2012 quarterly financial statements and do affect the Company’s income from operations and net income (loss) in its restated financial statements.

Based on the results of the Company’s internal investigation, and the financial impact thereof on prior financial periods, the Boards of Directors of the Company and Holdings, at meetings held on November 1, 2012, determined that the Company’s financial statements (i) for the fiscal years ended December 31, 2009, 2010 and 2011, included in the Company’s Annual Reports on Form 10-K for the years then ended and Ernst & Young LLP’s reports thereon, (ii) for the interim periods within such fiscal years included in the Company’s Quarterly Reports on Form 10-Q, and (iii) for the quarters ended March 31, 2012, and June 30, 2012, included in the Company’s Quarterly Reports on Form 10-Q (the “Affected Financial Statements”), should no longer be relied upon. As a result, the Company has restated the Affected Financial Statements to reflect the effect of such financial misconduct on the Affected Financial Statements. This Form 10-Q/A contains more information about the restatement in Note 2 to our consolidated financial statements “Restatement of Consolidated Financial Statements,” which accompanies the financial statements in Item 1 of this report. Additionally, more information regarding the internal investigation is included in Part II, Item 1 of this report.

Items Amended in This Filing

For the convenience of the reader, this Amended Filing sets forth the Original Filing, as modified and superseded where necessary to reflect the restatement. The following items have been amended as a result of, and to reflect, the restatement:

 

 

Part I – Item 1. Financial Statements

 

 

Part I – Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

Part I – Item 4. Controls and Procedures

 

 

Part II – Item 1. Legal Proceedings

Although this Amended Filing amends and restates the Original Filing in its entirety, it amends only the items of the Original Filing identified above to reflect the restatement. Except for the foregoing amended information or where otherwise noted, this Form 10-Q/A does not reflect events that occurred after the Original Filing or modify or update those disclosures affected by subsequent events. Rather, except as described above, information is unchanged and reflects the disclosures made at the time of the Original Filing on May 11, 2012. Events occurring after the date of the Original Filing (other than items changed as a result of the restatement as well as certain disclosures made to reflect subsequent events, all contained in our consolidated financial statements which occurred after March 31, 2012 through the date of filing), have been or will be addressed in our amended Quarterly Report on Form 10-Q/A for the quarterly period ended June 30, 2012 and our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2012 and/or in other reports filed with the SEC subsequent to the Original Filing.

The sections of the Original Filing affected by the restatement should no longer be relied upon. In addition, this Form 10-Q/A has been repaginated and references to “Form 10-Q” have been revised to refer to “Form 10-Q/A.”

In addition, in accordance with applicable SEC rules, this Amended Filing includes new currently dated certifications from the Company’s Chief Executive Officer and Chief Financial Officer, as required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002. The certifications of the Company’s Chief Executive Officer and Chief Financial Officer are attached to this Amended Filing as Exhibits 31.1, 31.2, 32.1 and 32.2.

Restatement of Other Financial Statements

In addition to this Amended Filing, we have filed or will file an amendment to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2012 (the “June 10-Q/A”) and to our Annual Report on Form 10-K for the year ended December 31, 2011 (the “2011 10-K/A”). The June 10-Q/A and 2011 10-K/A are being filed to restate our audited and unaudited financial statements and related financial information for the periods contained in those reports and to amend certain other Items within the previously-issued filings.

Internal Control Considerations

As discussed in Part I — Item 4 of this Amended Filing, the Board of Directors of the Company concluded on November 1, 2012, that material weaknesses in the internal control over financial reporting exist at the Company, and consequently the Board of Directors has determined that management’s report on internal control over financial reporting as of December 31, 2009, 2010, and 2011, included in the Company’s Annual Reports on Form 10-K for the years then ended, should no longer be relied upon. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a

 

4


Table of Contents

timely basis. The existence of one or more material weaknesses precludes a conclusion by management that a corporation’s internal control over financial reporting is effective. The Company is currently in the process of remediating the weaknesses in internal control over financial reporting referred to above by designing and implementing new procedures and controls throughout the Company and its subsidiaries.

For a discussion of management’s consideration of our disclosure controls and procedures and the material weaknesses identified, see Part I — Item 4 included in this Amended Filing.

 

5


Table of Contents
         Page  
  PART I – FINANCIAL INFORMATION   
Item 1.   Financial Statements   
 

Consolidated Balance Sheets as of March 31, 2012 (successor, unaudited), and December  31, 2011 (successor, audited) – Restated

     8   
 

Unaudited Consolidated Statements of Operations and Comprehensive Income (Loss) for the three months ended March 31, 2012 (successor), and 2011 (predecessor) – Restated

     9   
 

Unaudited Consolidated Statements of Cash Flows for the three months ended March  31, 2012 (successor), and 2011 (predecessor) – Restated

     10   
 

Notes to Consolidated Financial Statements

     11   
Item 2.  

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

     30   
Item 3.  

Quantitative and Qualitative Disclosures about Market Risk

     37   
Item 4.  

Controls and Procedures

     37   
  PART II – OTHER INFORMATION   
Item 1.   Legal Proceedings      40   
Item 1A.   Risk Factors      40   
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds      41   
Item 3.   Defaults Upon Senior Securities      41   
Item 4.   Mine Safety Disclosures      41   
Item 5.   Other Information      41   
Item 6.   Exhibits      41   
SIGNATURES      42   

EXHIBIT INDEX

     43   

 

6


Table of Contents

Cautionary Note Regarding Forward-Looking Statements

Forwarding-Looking Statements

Certain statements in this Quarterly Report on Form 10-Q/A (this “Quarterly Report”) are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Forward-looking statements include, without limitation, estimates, projections and other statements regarding our operating, growth and acquisition strategies, cost savings initiatives, industry dynamics, economic conditions, regulatory environment, debt compliance, liquidity and capital resources, and operating results, and the assumptions upon which those statements are based.

Forward-looking statements may be included or incorporated by reference throughout this Quarterly Report, including, without limitation, in the sections under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions.

Forward-looking statements are based on current expectations and assumptions, which are subject to risks and uncertainties that may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included under the caption “Risk Factors” in our Annual Report on Form 10-K/A for the year ended December 31, 2011, filed with the U.S. Securities and Exchange Commission (the “SEC”) on January 29, 2013 (our “Amended 2011 Annual Report”).

Presentation of Information

As used in this Quarterly Report, the terms “we,” “us,” “our,” “the Company,” “our Company” or similar terms refer to iPayment Holdings, Inc. and its subsidiaries, unless otherwise stated or required by the context. The term “iPayment” refers to iPayment, Inc. and “Holdings” refers to iPayment Holdings, Inc., in each case, without their subsidiaries. Holdings is a holding company that does not have any operations or material assets other than the direct and indirect ownership of all of the capital stock of iPayment and its subsidiaries, respectively.

This report includes financial information for Holdings and its consolidated subsidiaries and iPayment and its consolidated subsidiaries. Except as otherwise indicated, the results of operations of Holdings and its consolidated subsidiaries and iPayment and its consolidated subsidiaries are the same.

 

7


Table of Contents

PART I FINANCIAL INFORMATION

Item 1. Financial Statements

CONSOLIDATED BALANCE SHEETS

 

      iPAYMENT, INC.     iPAYMENT HOLDINGS, INC.  

(Dollars in thousands , except share data)

   March 31,
2012 (Restated)
    December 31,
2011 (Restated)
    March 31,
2012  (Restated)
    December 31,
2011 (Restated)
 
     Successor
(Unaudited)
    Successor
(Audited)
    Successor
(Unaudited)
    Successor
(Audited)
 
ASSETS         

Current assets:

        

Cash and cash equivalents

   $ 201      $ 1      $ 201      $ 1   

Accounts receivable, net of allowance for doubtful accounts of $1,547 and $1,580 at March 31, 2012 and December 31, 2011, respectively

     32,759        33,765        32,759        33,765   

Prepaid expenses and other current assets

     2,232        2,104        2,232        2,104   

Deferred tax assets

     2,988        2,988        2,988        2,988   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total current assets

     38,180        38,858        38,180        38,858   

Restricted cash

     537        542        537        542   

Property and equipment, net

     5,988        5,530        5,988        5,530   

Merchant portfolio and other intangible assets, net of accumulated amortization of $57,679 and $41,725 at March 31, 2012 and December 31, 2011, respectively

     244,682        259,957        244,682        259,957   

Goodwill

     669,562        669,562        670,362        670,362   

Other assets, net

     23,082        23,862        26,205        27,051   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total assets

   $ 982,031      $ 998,311      $ 985,954      $ 1,002,300   
  

 

 

   

 

 

   

 

 

   

 

 

 

LIABILITIES and STOCKHOLDER’S EQUITY

        

Current liabilities:

        

Accounts payable

   $ 3,412      $ 5,773      $ 3,412      $ 5,773   

Income taxes payable, net

     2,911        6,650        3,218        3,820   

Accrued interest

     16,934        6,750        24,242        9,186   

Accrued liabilities and other

     21,536        21,899        21,624        21,935   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total current liabilities

     44,793        41,072        52,496        40,714   

Deferred tax liabilities, net

     27,266        27,267        27,058        27,059   

Long-term debt

     755,852        774,284        884,747        903,141   

Other liabilities

     1,371        1,339        1,372        1,339   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities

     829,282        843,962        965,673        972,253   
  

 

 

   

 

 

   

 

 

   

 

 

 

Commitments and contingencies (Note 9)

        

Equity

        

Common stock of iPayment, Inc., $0.01 par value; 1,000 shares authorized, 100 shares issued and outstanding at March 31, 2012 and December 31, 2011

     165,764        165,764        —          —     

Common stock of iPayment Holdings, Inc., $0.01 par value; 8,000,000 shares authorized, 4,875,000 shares issued and outstanding at March 31, 2012 and December 31, 2011

     —          —          45,268        45,268   

Accumulated deficit

     (13,015     (11,415     (24,987     (15,221
  

 

 

   

 

 

   

 

 

   

 

 

 

Total stockholder’s equity

     152,749        154,349        20,281        30,047   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities and stockholder’s equity

   $ 982,031      $ 998,311      $ 985,954      $ 1,002,300   
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

8


Table of Contents

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

(Unaudited)

 

    iPAYMENT, INC.     iPAYMENT HOLDINGS, INC.  

(Dollars in thousands)

  Three Months Ended
March 31, 2012
(Restated)
    Three Months Ended
March 31, 2011
(Restated)
    Three Months Ended
March 31, 2012
(Restated)
    Three Months Ended
March 31, 2011
(Restated)
 
    Successor     Predecessor     Successor     Predecessor  

Revenues

  $ 165,132      $ 169,613      $ 165,132      $ 169,613   

Operating expenses:

       

Interchange

    81,858        90,728        81,858        90,728   

Other costs of services

    65,013        54,164        65,046        54,164   

Selling, general and administrative

    4,232        4,290        4,250        4,290   

Embezzlement costs

    922        375        922        375   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

    152,025        149,557        152,076        149,557   
 

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

    13,107        20,056        13,056        20,056   

Other expense:

       

Interest expense, net

    16,386        7,901        21,362        7,901   

Other income, net

    (581     (30     (581     (30
 

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before income taxes

    (2,698     12,185        (7,725     12,185   

Income tax (benefit) provision

    (1,097     4,421        2,040        4,421   
 

 

 

   

 

 

   

 

 

   

 

 

 

Total comprehensive income (loss)

  $ (1,601   $ 7,764      $ (9,765   $ 7,764   
 

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

9


Table of Contents

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

    iPAYMENT, INC.     iPAYMENT HOLDINGS, INC.  

(Dollars in thousands)

  Three Months Ended
March 31,

2012 (Restated)
    Three Months Ended
March 31,

2011 (Restated)
    Three Months Ended
March 31,

2012 (Restated)
    Three Months Ended
March 31,

2011 (Restated)
 
    Successor        Predecessor        Successor        Predecessor   

Cash flows from operating activities

       

Net income (loss)

  $ (1,601   $ 7,764      $ (9,765   $ 7,764   

Adjustments to reconcile net income (loss) to net cash provided by operating activities

       

Depreciation and amortization

    16,577        10,377        16,577        10,377   

Noncash interest expense and other

    754        646        3,294        646   

Loss on disposal of property and equipment

    364        —          364        —     

Changes in assets and liabilities

       

Accounts receivable

    1,006        (876     1,006        (876

Prepaid expenses and other current assets

    (128     (298     (128     (298

Other assets

    (585     (162     (585     (162

Accounts payable and income taxes payable

    (6,100     (8,251     (2,963     (8,251

Accrued interest

    10,184        4,621        12,620        4,621   

Accrued liabilities and other

    (331     (1,019     (280     (1,019
 

 

 

   

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

    20,140        12,802        20,140        12,802   
 

 

 

   

 

 

   

 

 

   

 

 

 

Cash flows from investing activities

       

Change in restricted cash

    5        (2     5        (2

Expenditures for property and equipment

    (1,445     (739     (1,445     (739

Payments for prepaid residual expenses

    —          (488     —          (488
 

 

 

   

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

    (1,440     (1,229     (1,440     (1,229
 

 

 

   

 

 

   

 

 

   

 

 

 

Cash flows from financing activities

       

Net repayments on revolving facility

    (10,500     (5,750     (10,500     (5,750

Repayments of debt

    (8,000     (5,823     (8,000     (5,823
 

 

 

   

 

 

   

 

 

   

 

 

 

Net cash used in financing activities

    (18,500     (11,573     (18,500     (11,573
 

 

 

   

 

 

   

 

 

   

 

 

 

Net increase in cash and cash equivalents

    200        —          200        —     

Cash and cash equivalents, beginning of period

    1        1        1        1   
 

 

 

   

 

 

   

 

 

   

 

 

 

Cash and cash equivalents, end of period

  $ 201      $ 1      $ 201      $ 1   
 

 

 

   

 

 

   

 

 

   

 

 

 

Supplemental disclosure of cash flow information:

       

Cash paid during the period for income taxes

  $ 2,647      $ 11,924      $ 2,647      $ 11,924   

Cash paid during the period for interest

  $ 5,448      $ 2,635      $ 5,448      $ 2,635   

See accompanying notes to consolidated financial statements.

 

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Notes to Consolidated Financial Statements

(1) Organization, Business and Basis of Presentation

Organization

We are a provider of credit and debit card payment processing services to small merchants across the United States. We conduct all of our operations through our operating company, iPayment, Inc. (“iPayment”), and its subsidiaries. iPayment and its direct parent, iPayment Holdings, Inc. (“Holdings”), are incorporated in Delaware. Holdings is a holding company that does not have any operations or material assets other than the direct and indirect ownership of all of the capital stock of iPayment and its subsidiaries, respectively. All of the capital stock of Holdings is owned by iPayment Investors, L.P. (“iPayment Investors”). All of the partnership interests of iPayment Investors are owned by Carl A. Grimstad, iPayment’s Chairman and Chief Executive Officer, and certain entities and persons affiliated with him.

On May 23, 2011, iPayment Investors and its general partner, iPayment GP, LLC (“iPayment GP”), completed the redemption (the “Equity Redemption”) of all of the direct and indirect equity interests in iPayment Investors and iPayment GP of (i) Gregory Daily, iPayment’s former Chairman and Chief Executive Officer and (ii) the trusts for the benefit of, and other entities controlled by, members of Mr. Daily’s family that held equity interests in iPayment Investors. The Equity Redemption resulted in a change in control and accordingly has been accounted for as a business combination in accordance with ASC 805 “Business Combinations.”

The Equity Redemption, together with a refinancing of substantially all of iPayment’s and iPayment Investors’ then existing debt, were funded with the proceeds of new senior secured credit facilities entered into, and securities issued, on May 6, 2011, which we define in Note 3 below as the “Refinancing.” Please refer to Notes 3 and 6 for further discussion of the Equity Redemption and the Refinancing.

Business

Our payment processing services enable our merchants to accept credit cards as well as other forms of payment, including debit cards, checks, gift cards and loyalty programs in traditional card-present, or swipe transactions, as well as in card-not-present transactions, such as those done over the phone or through the internet. We market and sell our services primarily through independent sales groups (“ISGs”), which are non-employee, external sales organizations and other third party resellers of our products and services. We also market our services directly to merchants through electronic media, telemarketing and other programs, including utilizing partnerships with other companies that market products and services to small businesses. In addition, we partner with banks such as Wells Fargo to sponsor us for membership in the Visa, MasterCard or other card associations and to settle transactions with merchants. We perform core functions for small merchants such as application processing, underwriting, account set-up, risk management, fraud detection, merchant assistance and support, equipment deployment and chargeback services, primarily in our main operating center in Westlake Village, California.

In May 2011, iPayment completed an offering of $400.0 million in aggregate principal amount of 10.25% Senior Notes due 2018 (the “10.25% Notes”) and entered into its new senior secured credit facilities consisting of (i) a $375.0 million term facility and (ii) a $75.0 million revolving facility (the “Senior Secured Credit Facilities”). The new revolving facility will mature on May 6, 2016, and the new term facility will mature on May 8, 2017. Also in May 2011, Holdings completed an offering of 125,000 units (the “Units”), consisting of $125.0 million in aggregate principal amount of 15.00%/15.00% Senior Notes due 2018 (the “15.00%/15.00% Notes”) and 125,000 warrants (the “Warrants”) to purchase common stock of Holdings. The Warrants represent an aggregate 2.5% of the outstanding common stock of Holdings on a fully diluted basis. The Senior Secured Credit Facilities, the 10.25% Notes and the 15.00%/15.00% Notes are discussed further in Note 6.

On November 14, 2012, we entered into a waiver, consent and amendment (the “Waiver”) with a majority of the lenders under the Senior Secured Credit Facilities. Among other things, the Waiver waives (a) defaults arising from the restatement of our financial statements (i) for the fiscal years ended December 31, 2008, 2009, 2010, and 2011 included in the Company’s Annual Reports on Form 10-K for the years then ended, (ii) for the interim periods within such fiscal years included in the Company’s Quarterly Reports on Form 10-Q and (iii) for the quarters ended March 31, 2012 and June 30, 2012 included in the Company’s Quarterly Reports on Form 10-Q and (b) until February 1, 2013, the Company’s failure to timely provide to the Administrative Agent its 3rd Quarter 2012 financial statements. Finally, under the terms of the Waiver, the revolving lenders under the Senior Secured Credit Facilities agreed that, absent any default thereunder that may occur after the date of the Waiver, each such revolving lender would continue to honor requests for borrowing under the Senior Secured Credit Facilities’ revolving credit facility, provided that the aggregate principal amount of all borrowings thereunder do not exceed $58 million, a reduction from $95 million, which represents the total revolving

 

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commitments under the Senior Secured Credit Facility. Such reduction in revolving commitments shall no longer be in effect upon the Company’s delivery, on or prior to February 1, 2013, of the restated financial statements and the Company’s unaudited financial statements (and related documentation) for the quarterly period ended September 30, 2012. Following receipt of the Waiver, the Company borrowed amounts under the Senior Secured Credit Facilities’ revolving credit facility so as to make the scheduled interest payments due on November 15, 2012 under the indentures related to the Company’s 10.25% Notes and Holdings’ 15.00%/15.00% Notes.

Basis of Presentation

The accompanying consolidated financial statements of iPayment and Holdings have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) and reflect all adjustments, which are of a normal and recurring nature, that are, in the opinion of management, necessary for a fair presentation of the consolidated financial position and results of operations for the related periods. All significant intercompany transactions and balances have been eliminated in consolidation. Certain prior year amounts have been reclassified to conform to the current year presentation. The consolidated results of operations for any interim periods are not necessarily indicative of results to be expected for the full year.

As a result of the Equity Redemption, as further discussed in Note 3, our results of operations, financial position and cash flows prior to the date of the Equity Redemption are presented as the “Predecessor.” The financial effects of the Equity Redemption and our results of operations, financial position and cash flows following the Equity Redemption are presented as the “Successor.” Accordingly, as used in these notes to the consolidated financial statements, the terms “first three months of 2012” and “three months ended March 31, 2012,” refer to the results of the Successor entities and the terms “first three months of 2011” and “three months ended March 31, 2011,” refer to the results of the Predecessor entities for such periods.

Use of Estimates

The preparation of our financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of our financial statements. Estimates and assumptions also affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. As a result of the change in control discussed in Note 3 and the application of ASC 805, we engaged an independent, third party valuation firm to assist in evaluating the fair value of certain assets and liabilities as of May 23, 2011. The results of this valuation are further discussed in Note 3 below.

Revenue and Cost Recognition

Substantially all of our revenues are generated from fees charged to merchants for payment processing services. We typically charge these merchants a rate, primarily based upon each merchant’s monthly charge volume and risk profile. Our fees principally consist of discount fees, which are a percentage of the dollar amount of each transaction. We recognize discounts and other fees related to payment transactions at the time the merchant’s transactions are processed. Related interchange and assessment costs are also recognized at that time. We derive the balance of our revenues from a variety of fixed transaction or service fees, including fees for monthly minimum charge volume requirements, statement fees, annual fees, payment card industry compliance fees, ancillary products and fees for other miscellaneous services, such as handling chargebacks. We recognize revenues derived from service fees at the time the service is performed.

We follow the requirements included in the Revenue Recognition Topic of ASC 605 “Reporting Revenue Gross as a Principal Versus Net as an Agent.” Generally, where we have ownership of the merchant agreement, credit risk and ultimate responsibility for the merchant, revenues are reported at the time of sale on a gross basis equal to the full amount of the discount charged to the merchant. This amount includes interchange paid to card issuing banks and assessments paid to payment card associations pursuant to which such parties receive payments based primarily on processing volume for particular groups of merchants. Interchange fees are recognized at the time transactions are processed. Revenues generated from certain bank portfolios acquired from First Data Merchant Services Corporation and other sources are reported net of interchange, as required by ASC Topic 605, because we may not have credit risk, portability or the ultimate responsibility for the merchant accounts.

Other Costs of Services

Other costs of services include costs directly attributable to our provision of payment processing and related services to our merchants and primarily includes residual payments to ISGs, which are commissions we pay to our ISGs based upon a percentage of the net revenues we generate from their merchant referrals, and assessment fees payable to card associations, which are a percentage of the charge volume we generate from Visa and MasterCard. In addition, other costs of services includes telecommunications costs, personnel costs, occupancy costs, losses due to merchant defaults, other miscellaneous merchant supplies and services expenses, amortization, depreciation, bank sponsorship costs and other third-party processing costs.

 

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Financial Instruments

ASC 820 “Fair Value Measurement and Disclosures” establishes a framework for measuring fair value and a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. The three levels are defined as follows:

 

   

Level 1: Observable quoted prices in active markets for identical assets and liabilities.

 

   

Level 2: Observable quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.

 

   

Level 3: Model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash-flow models and similar techniques.

We believe the carrying amounts of financial instruments at March 31, 2012, approximate fair value. Due to the short maturities of the cash and cash equivalents and accounts receivable, carrying amounts approximate the respective fair values. The carrying value of the 10.25% Notes was $400.0 million as of March 31, 2012. We estimate its fair value to be approximately $367.0 million, considering executed trades occurring around March 31, 2012. The carrying value of the term loan under the Senior Secured Credit Facilities, net of discount, was $350.9 million as of March 31, 2012. We estimate its fair value to be approximately $351.7 million, considering executed trades occurring around March 31, 2012. The carrying value of the 15.00%/ 15.00% Notes was $128.9 million as of March 31, 2012. We estimate its fair value to be approximately $107.0 million, considering executed trades occurring around March 31, 2012. The fair value of the 10.25% Notes, the Senior Secured Credit Facilities, and the 15.00%/15.00% Notes are estimated using direct and indirect observable market information and are classified within Level 2 of the fair value hierarchy, as defined by ASC 820. We are contractually obligated to repay our borrowings in full and we do not believe the creditors under our borrowing arrangements are willing to settle these instruments with us at their estimated fair values indicated herein.

Amortization of Intangible Assets

Purchased merchant processing portfolios are recorded at cost and are evaluated by management for impairment at the end of each fiscal quarter through review of actual attrition and cash flows generated by the portfolios in relation to the expected attrition and cash flows and the recorded amortization expense. Amortization of intangible assets results from our acquisitions of portfolios of merchant contracts, revenue streams related to residual agreements related to merchant portfolios, or residual buyouts or acquisitions of a business where we allocated a portion of the purchase price to the existing merchant processing portfolios and other intangible assets.

The estimated useful lives of our merchant processing portfolios are assessed by evaluating each portfolio to ensure that the recognition of the costs of revenues, represented by amortization of the intangible assets, approximate the distribution of the expected revenues from each processing portfolio. If, upon review, the actual costs of revenues differ from the expected costs of revenues, we will adjust amortization expense accordingly. Historically, we have experienced an average monthly volume attrition of approximately 1.5% to 2.5% of our total charge volume.

We utilize an accelerated method of amortization over a 15-year period, which we believe approximates the distribution of actual cash flows generated by our merchant processing portfolios. All other intangible assets are amortized using the straight-line method over an estimated life of three to seven years. For the three months ended March 31, 2012, amortization expense related to our merchant processing portfolios and other intangible assets was $16.0 million. For the three months ended March 31, 2011, amortization expense related to our merchant processing portfolios and other intangible assets was $9.9 million.

In addition, we have implemented both quarterly and annual procedures to determine whether a significant change in the trend of the current attrition rates being used has occurred on a portfolio-by-portfolio basis. In reviewing the current attrition rate trends, we consider relevant benchmarks such as charge volume, revenues, number of merchant accounts, gross profit and future expectations of the aforementioned factors compared to historical amounts and rates. If we identify any significant changes or trends in the attrition rate of any portfolio, we will adjust our current and prospective estimated attrition rates so that the amortization expense better approximates the distribution of actual cash flows generated by the merchant processing portfolios. Any adjustments made to the amortization schedules would be reported in the current consolidated statements of operations and comprehensive income (loss) and on a prospective basis until further evidence becomes apparent. As a result of the Equity Redemption, we appraised merchant processing portfolios as of May 23, 2011. There were no material favorable or unfavorable trends identified in the attrition rates used for the three months ended March 31, 2012. Consequently, there were no related adjustments to amortization expense for these periods. Please refer to Note 3 for further discussion.

Our intangible assets are amortized over their estimated lives, except the “iPayment, Inc.” trade name, which was determined to have an indefinite life as there are no legal, regulatory, contractual, economic or other factors that limit the useful life of the intangible asset to us, and we have no plans to cease using such name. We believe the trade name has an inherent value due to brand strength.

 

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Common Stock

iPayment and Holdings have 100 and 4,875,000 shares of common stock, respectively, that are issued and outstanding at March 31, 2012. The Company has elected not to present earnings per share data as management believes such presentation would not be meaningful. There is no established public trading market for our common stock or for the warrants. No warrants were exercised as of March 31, 2012.

(2) Restatement of Consolidated Financial Statements

In August 2012, as disclosed in the Company’s Current Reports on Form 8-K filed on September 12, 2012, and November 5, 2012, the Company and Holdings were presented with accusations from one of the Company’s employees that certain of the Company’s employees and outside contractors had engaged in financial misconduct. Following an initial inquiry into these accusations by the Company, the Board of Directors of the Company and management conducted an internal investigation of the alleged misconduct. During the course of the Company’s investigation, certain executives of the Company and Holdings were terminated or resigned.

The Company’s internal investigation revealed financial misconduct by certain former officers and employees of the Company and certain of its outside contractors. Such misconduct occurred in five principal areas: (i) failure to maintain an adequate control environment that set a proper culture within our operations; (ii) creation of false obligations to make residual and other payments (which resulted in the Company making such payments in respect of merchant accounts that were not subject to legitimate payment obligations); (iii) overstatement of certain vendor invoices, principally in the information technology area; (iv) falsification of certain employee expense reimbursements and other payments; and (v) the posting of manual journal entries without sufficient supporting documentation, adequate review, and approval. The Company believes that the foregoing activities, which generally occurred over a period from the third quarter of 2008 through September 2012, involved a total loss of funds to the Company of approximately $10.4 million through March 31, 2012 ($11.9 million through September 30, 2012). The adjustments related to the financial misconduct and the recording of other prior period adjustments not related to the financial misconduct are set forth in the table below.

 

     Cumulative
embezzlement costs
through March 31,
2012
     iPayment Holdings, Inc. &
iPayment, Inc. (Successor)
    Cumulative
embezzlement
costs through
December 31,
2011
 

(Dollars in thousands)

      Three Months Ended
March 31, 2012
   

Embezzlement costs

       

Residual expense

   $ 4,099       $ 427      $ 3,672   

Property and equipment

     2,149         207        1,942   

Other intangible assets

     1,970         288        1,682   

Residual buyout

     1,625         —          1,625   

Travel and entertainment

     229         —          229   

Prepaids and other receivables

     208         —          208   

Other

     123         —          123   
  

 

 

    

 

 

   

 

 

 

Total embezzlement costs

   $ 10,403         922      $ 9,481   
  

 

 

      

 

 

 

Embezzlement costs previously included in the statements of operations as:

       

Other costs of services

        (647  

Prior period adjustments not related to fraudulent transactions

       

Reversal of residual buyout amortization adjustment

        1,996     

Reversal of deferred gain amortization

        230     

Tax adjustments

       

Tax effect of the above recorded adjustments

        (134  

Prior period tax adjustments not related to fraudulent transactions

        1,473     
     

 

 

   

Net decrease

        3,840     

Net loss, as previously reported (1)

        (5,925  
     

 

 

   

Net loss, as restated (1)

      $ (9,765  
     

 

 

   

 

(1) For 2012, net loss is for iPayment Holdings, Inc.

Total embezzlement costs incurred by the Company cumulatively through March 31, 2012 were $10.4 million. $0.9 million of such identified losses were incurred during the three months ended March 31, 2012. $0.6 million of the identified losses for three months ended March 31, 2012 were classified as residual and other expenses within other costs of services in the consolidated financial statements during the period in which the misconduct took place. The Company reclassified these costs as embezzlement costs included in total operating expenses. These reclassified embezzlement costs had no effect on the Company’s income from operations and net income (loss) in its previously issued March 31, 2012 quarterly financial statements.

 

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The remaining amount of such identified embezzlement costs totaling $0.3 million for the three months ended March 31, 2012 was capitalized in the financial statements as property and equipment or other intangible assets during the period in which the misconduct took place. Such losses were written off as embezzlement costs in the restated March 31, 2012 quarterly financial statements and do affect the Company’s income from operations and net income (loss) in its restated financial statements.

In addition to the items described above, the Company also included in the restated consolidated financial statements other previously unrecorded adjustments identified during the preparation of the consolidated financial statements at March 31, 2012. These adjustments primarily were:

 

   

Reversal of an amortization adjustment of $2.0 million recorded in the three months ended March 31, 2012 related to excess residual buy-out amortization expense that was corrected in the 2011 restated consolidated financial statements filed in the Amended 2011 Annual Report; and

 

   

Reversal of an excess tax amortization adjustment of $1.4 million recorded in the three months ended March 31, 2012 related to tax basis goodwill that was corrected in the 2011 restated consolidated financial statements filed in the Amended 2011 Annual Report.

The impact of all items discussed above on the consolidated balance sheets, consolidated statements of operations and comprehensive income (loss), and consolidated statements of cash flows is shown in the accompanying tables.

 

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Consolidated Balance Sheet (iPayment, Inc. and iPayment Holdings, Inc.) – As of March 31, 2012 (Unaudited)

 

      iPayment, Inc.     iPayment Holdings, Inc.  
      March 31, 2012     March 31, 2012  

(Dollars in thousands, except share data)

   As Previously
Reported
    Adjustments     Restated     As Previously
Reported
    Adjustments     Restated  
ASSETS             

Current assets:

            

Cash and cash equivalents

   $ 201      $ —        $ 201      $ 201      $ —        $ 201   

Accounts receivable, net of allowance for doubtful accounts of $1,547 ($940 as previously reported)

     32,955        (196     32,759        32,955        (196     32,759   

Prepaid expenses and other current assets

     2,296        (64     2,232        2,296        (64     2,232   

Deferred tax assets

     3,306        (318     2,988        3,306        (318     2,988   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total current assets

     38,758        (578     38,180        38,758        (578     38,180   

Restricted cash

     537        —          537        537        —          537   

Property and equipment, net

     7,224        (1,236     5,988        7,224        (1,236     5,988   

Merchant portfolios and other intangible assets, net of accumulated amortization of $57,679 ($57,288 as previously reported)

     246,846        (2,164     244,682        246,846        (2,164     244,682   

Goodwill

     669,483        79        669,562        670,283        79        670,362   

Other assets, net

     23,019        63        23,082        26,142        63        26,205   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total assets

   $ 985,867      $ (3,836   $ 982,031      $ 989,790      $ (3,836   $ 985,954   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
LIABILITIES and STOCKHOLDER’S EQUITY             

Current liabilities:

            

Accounts payable

   $ 3,412      $ —        $ 3,412      $ 3,412      $ —        $ 3,412   

Income taxes payable

     3,688        (777     2,911        2,243        975        3,218   

Accrued interest

     16,934        —          16,934        24,242        —          24,242   

Accrued liabilities and other

     22,602        (1,066     21,536        22,690        (1,066     21,624   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total current liabilities

     46,636        (1,843     44,793        52,587        (91     52,496   

Deferred tax liabilities

     28,604        (1,338     27,266        28,396        (1,338     27,058   

Long-term debt

     755,852        —          755,852        884,747        —          884,747   

Other liabilities

     1,477        (106     1,371        1,478        (106     1,372   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities

     832,569        (3,287     829,282        967,208        (1,535     965,673   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Commitments and contingencies (Note 9)

            

Equity

            

Common stock of iPayment, Inc., $0.01 par value; 1,000 shares authorized, 100 shares issued and outstanding

     165,764        —          165,764        —          —          —     

Common stock of iPayment Holdings, Inc., $0.01 par value; 8,000,000 shares authorized, 4,875,000 shares issued and outstanding

     —          —          —          45,268        —          45,268   

Accumulated deficit

     (12,466     (549     (13,015     (22,686     (2,301     (24,987
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total stockholder’s equity

     153,298        (549     152,749        22,582        (2,301     20,281   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities and stockholder’s equity

   $ 985,867      $ (3,836   $ 982,031      $ 989,790      $ (3,836   $ 985,954   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

 

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Consolidated Balance Sheet (iPayment, Inc. and iPayment Holdings, Inc.) – As of December 31, 2011

 

      iPayment, Inc.     iPayment Holdings, Inc.  
      December 31, 2011     December 31, 2011  

(Dollars in thousands, except share data)

   As Previously
Reported
    Adjustments     Restated     As  Previously
Reported
    Adjustments     Restated  
ASSETS             

Current assets:

            

Cash and cash equivalents

   $ 1      $ —        $ 1      $ 1      $ —        $ 1   

Accounts receivable, net of allowance for doubtful accounts of $1,580 ($973 as previously reported)

     33,961        (196     33,765        33,961        (196     33,765   

Prepaid expenses and other current assets

     2,221        (117     2,104        2,221        (117     2,104   

Deferred tax assets

     3,306        (318     2,988        3,306        (318     2,988   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total current assets

     39,489        (631     38,858        39,489        (631     38,858   

Restricted cash

     542        —          542        542        —          542   

Property and equipment, net

     6,636        (1,106     5,530        6,636        (1,106     5,530   

Merchant portfolios and other intangible assets, net of accumulated amortization of $41,725 ($43,220 as previously reported)

     259,980        (23     259,957        259,980        (23     259,957   

Goodwill

     669,483        79        669,562        670,283        79        670,362   

Other assets, net

     23,798        64        23,862        26,987        64        27,051   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total assets

   $ 999,928      $ (1,617   $ 998,311      $ 1,003,917      $ (1,617   $ 1,002,300   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
LIABILITIES and STOCKHOLDER’S EQUITY             

Current liabilities:

            

Accounts payable

   $ 5,826      $ (53   $ 5,773      $ 5,826      $ (53   $ 5,773   

Income taxes payable

     6,445        205        6,650        3,615        205        3,820   

Accrued interest

     6,750        —          6,750        9,186        —          9,186   

Accrued liabilities and other

     23,195        (1,296     21,899        23,231        (1,296     21,935   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total current liabilities

     42,216        (1,144     41,072        41,858        (1,144     40,714   

Deferred tax liabilities

     29,178        (1,911     27,267        28,970        (1,911     27,059   

Long-term debt

     774,284        —          774,284        903,141        —          903,141   

Other liabilities

     1,440        (101     1,339        1,440        (101     1,339   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities

     847,118        (3,156     843,962        975,409        (3,156     972,253   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Commitments and contingencies

            

Equity

            

Common stock of iPayment, Inc., $0.01 par value; 1,000 shares authorized, 100 shares issued and outstanding

     165,764        —          165,764        —          —          —     

Common stock of iPayment Holdings, Inc., $0.01 par value; 8,000,000 shares authorized, 4,875,000 shares issued and outstanding

     —          —          —          45,268        —          45,268   

Accumulated deficit

     (12,954     1,539        (11,415     (16,760     1,539        (15,221
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total stockholder’s equity

     152,810        1,539        154,349        28,508        1,539        30,047   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total liabilities and stockholder’s equity

   $ 999,928      $ (1,617   $ 998,311      $ 1,003,917      $ (1,617   $ 1,002,300   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents

Consolidated Statement of Operations and Comprehensive Income (Loss) (iPayment, Inc. and iPayment Holdings, Inc.) – Three Months Ended March 31, 2012 (Unaudited)

 

     iPayment, Inc.     iPayment Holdings, Inc.  
     Three Months Ended March 31, 2012     Three Months Ended March 31, 2012  

(Dollars in thousands)

   As Previously
Reported
    Adjustments     Restated     As Previously
Reported
    Adjustments     Restated  

Revenues

   $ 165,362      $ (230   $ 165,132      $ 165,362      $ (230   $ 165,132   

Operating expenses:

            

Interchange

     81,858        —          81,858        81,858        —          81,858   

Other costs of services

     63,664        1,349        65,013        63,697        1,349        65,046   

Selling, general and administrative

     4,232        —          4,232        4,250        —          4,250   

Embezzlement costs

     —          922        922        —          922        922   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses

     149,754        2,271        152,025        149,805        2,271        152,076   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     15,608        (2,501     13,107        15,557        (2,501     13,056   

Other expense:

            

Interest expense, net

     16,386        —          16,386        21,362        —          21,362   

Other income, net

     (581     —          (581     (581     —          (581
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Loss before income taxes

     (197     (2,501     (2,698     (5,224     (2,501     (7,725

Income tax provision (benefit)

     (684     (413     (1,097     701        1,339        2,040   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total comprehensive income (loss)

   $ 487      $ (2,088   $ (1,601   $ (5,925   $ (3,840   $ (9,765
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents

Consolidated Statement of Operations and Comprehensive Income (Loss) (iPayment, Inc. and iPayment Holdings, Inc.) – Three Months Ended March 31, 2011 (Unaudited)

 

     iPayment, Inc. and iPayment Holdings, Inc.  
     Three Months Ended March 31, 2011  

(Dollars in thousands)

   As Previously
Reported
    Adjustments     Restated  

Revenues

   $ 169,613      $ —        $ 169,613   

Operating expenses:

    

Interchange

     90,728        —          90,728   

Other costs of services

     54,741        (577     54,164   

Selling, general and administrative

     4,290        —          4,290   

Embezzlement costs

     —          375        375   
  

 

 

   

 

 

   

 

 

 

Total operating expenses

     149,759        (202     149,557   
  

 

 

   

 

 

   

 

 

 

Income from operations

     19,854        202        20,056   

Other expense:

    

Interest expense, net

     7,901        —          7,901   

Other income, net

     (30     —          (30
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     11,983        202        12,185   

Income tax provision

     4,421        —          4,421   
  

 

 

   

 

 

   

 

 

 

Total comprehensive income

   $ 7,562      $ 202      $ 7,764   
  

 

 

   

 

 

   

 

 

 

 

 

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Consolidated Statement of Cash Flows (iPayment, Inc. and iPayment Holdings, Inc.) – Three Months Ended March 31, 2012 (Unaudited)

 

     iPayment, Inc.     iPayment Holdings, Inc.  
     Three Months Ended March 31, 2012     Three Months Ended March 31, 2012  

(Dollars in thousands)

   As Previously
Reported
    Adjustments     Restated     As Previously
Reported
    Adjustments     Restated  

Cash flows from operating activities

            

Net income (loss)

   $ 487      $ (2,088   $ (1,601   $ (5,925   $ (3,840   $ (9,765

Adjustments to reconcile net income (loss) to net cash provided by operating activities

            

Depreciation and amortization

     14,801        1,776        16,577        14,801        1,776        16,577   

Noncash interest expense and other

     754        —          754        3,294        —          3,294   

Loss on disposal of property and equipment

     364        —          364        364        —          364   

Changes in assets and liabilities

            

Accounts receivable

     1,006        —          1,006        1,006        —          1,006   

Prepaid expenses and other current assets

     (75     (53     (128     (75     (53     (128

Other assets

     (1,447     862        (585     (1,447     862        (585

Accounts payable and income taxes payable

     (5,170     (930     (6,100     (3,785     822        (2,963

Accrued interest

     10,184        —          10,184        12,620        —          12,620   

Accrued liabilities and other

     (556     225        (331     (505     225        (280
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     20,348        (208     20,140        20,348        (208     20,140   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cash flows from investing activities

            

Change in restricted cash

     5        —          5        5        —          5   

Expenditures for property and equipment

     (1,653     208        (1,445     (1,653     208        (1,445
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

     (1,648     208        (1,440     (1,648     208        (1,440
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cash flows from financing activities

            

Net repayments on revolving facility

     (10,500     —          (10,500     (10,500     —          (10,500

Repayments of debt

     (8,000     —          (8,000     (8,000     —          (8,000
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net cash used in financing activities

     (18,500     —          (18,500     (18,500     —          (18,500
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net increase in cash and cash equivalents

     200        —          200        200        —          200   

Cash and cash equivalents, beginning of period

     1        —          1        1        —          1   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Cash and cash equivalents, end of period

   $ 201      $ —        $ 201      $ 201      $ —        $ 201   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Supplemental disclosure of cash flow information:

            

Cash paid during the period for income taxes

   $ 2,647      $ —        $ 2,647      $ 2,647      $ —        $ 2,647   

Cash paid during the period for interest

   $ 5,448      $ —        $ 5,448      $ 5,448      $ —        $ 5,448   

 

 

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Consolidated Statement of Cash Flows (iPayment, Inc. and iPayment Holdings, Inc.) – Three Months Ended March 31, 2011 (Unaudited)

 

     iPayment, Inc. and iPayment Holdings, Inc.  
     Three Months Ended March 31, 2011  

(Dollars in thousands)

   As  Previously
Reported
    Adjustments     Restated  

Cash flows from operating activities

      

Net income

   $ 7,562      $ 202      $ 7,764   

Adjustments to reconcile net income to net cash provided by operating activities

     —          —          —     

Depreciation and amortization

     10,523        (146     10,377   

Stock-based compensation

     —          —          —     

Noncash interest expense and other

     646        —          646   

Changes in assets and liabilities

      

Accounts receivable

     (876     —          (876

Prepaid expenses and other current assets

     (263     (35     (298

Other assets

     (162     —          (162

Accounts payable and income taxes payable

     (8,285     34        (8,251

Accrued interest

     4,621        —          4,621   

Accrued liabilities and other

     (964     (55     (1,019
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     12,802        —          12,802   
  

 

 

   

 

 

   

 

 

 

Cash flows from investing activities

      

Change in restricted cash

     (2     —          (2

Expenditures for property and equipment

     (739     —          (739

Payments for prepaid residual expenses

     (488     —          (488
  

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

     (1,229     —          (1,229
  

 

 

   

 

 

   

 

 

 

Cash flows from financing activities

      

Net repayments on revolving facility

     (5,750     —          (5,750

Repayments of debt

     (5,823     —          (5,823
  

 

 

   

 

 

   

 

 

 

Net cash used in financing activities

     (11,573     —          (11,573
  

 

 

   

 

 

   

 

 

 

Net increase in cash and cash equivalents

     —          —          —     

Cash and cash equivalents, beginning of period

     1        —          1   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents, end of period

   $ 1      $ —        $ 1   
  

 

 

   

 

 

   

 

 

 

Supplemental disclosure of cash flow information:

      

Cash paid during the period for income taxes

   $ 11,924      $ —        $ 11,924   

Cash paid during the period for interest

   $ 2,635      $ —        $ 2,635   

 

 

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Table of Contents

(3) Equity Redemption, Refinancing and Change in Control

In May 2009, a jury in the Superior Court of the State of California for the County of Los Angeles handed down a verdict in the amount of $300.0 million, plus punitive damages in the amount of $50.0 million, against Gregory Daily, iPayment’s former Chairman and Chief Executive Officer, in connection with litigation over Mr. Daily’s beneficial ownership in us. This lawsuit was brought against Mr. Daily individually and not in his previous capacities as the Chairman and Chief Executive Officer of iPayment. Neither iPayment, nor any other shareholders, officers, employees or directors were a party to this action. In response to the verdict, Mr. Daily filed for personal bankruptcy protection under Chapter 11 of the United States Bankruptcy Code in Nashville, Tennessee. On April 8, 2010, the United States Bankruptcy Court for the Middle District of Tennessee ordered the appointment of a trustee (the “Daily Bankruptcy Trustee”) to administer the estate of Mr. Daily.

On April 12, 2011, iPayment Investors and iPayment GP entered into a redemption agreement (the “Redemption Agreement”) with (i) Mr. Daily, (ii) the Daily Bankruptcy Trustee and (iii) the trusts for the benefit of, and other entities controlled by, members of Mr. Daily’s family that held equity interests in iPayment Investors (together with Mr. Daily and the Daily Bankruptcy Trustee, on behalf of the Daily bankruptcy estate, the “Daily Parties”). Pursuant to the Redemption Agreement, iPayment Investors and iPayment GP agreed to redeem from the Daily Parties, and the Daily Parties agreed to transfer and surrender to iPayment Investors and iPayment GP, as applicable, all of the equity interests of the Daily Parties in iPayment Investors and iPayment GP, representing approximately 65.8% of the outstanding equity of iPayment Investors, for an aggregate price of $118.5 million. The interests redeemed pursuant to the Redemption Agreement constituted all of the direct and indirect equity interests of the Daily Parties in the Company.

On May 6, 2011, iPayment completed the offering of the 10.25% Notes and the closing of the Senior Secured Credit Facilities. Also on May 6, 2011, Holdings completed the offering of the Units. The majority of the proceeds from the offerings of the 10.25% Notes and the Units, together with borrowings under the Senior Secured Credit Facilities, were used to (i) permanently repay all of the outstanding indebtedness under iPayment’s then existing senior secured credit facilities; (ii) redeem and satisfy and discharge all of iPayment’s then existing senior subordinated notes; (iii) redeem and satisfy and discharge all of iPayment Investors’ then existing PIK toggle notes and (iv) pay fees and expenses in connection with the offerings. All of the remainder of such proceeds and borrowings were used to consummate the Equity Redemption on May 23, 2011, including payment of the transaction fee discussed in Note 11 and other related fees and expenses. In these notes to the consolidated financial statements, we refer to the entry into the Senior Secured Credit Facilities, the offer and sale of the 10.25% Notes and the Units, including the application of the net proceeds of the 10.25% Notes and the Units and borrowings under the Senior Secured Credit Facilities as described above, as the “Refinancing.”

Upon the closing of the Equity Redemption, Mr. Daily resigned as a director and officer, as applicable, of iPayment GP, iPayment Investors and each of iPayment Investors’ subsidiaries, including his former positions as iPayment’s Chairman and Chief Executive Officer. In connection with Mr. Daily’s resignation, Carl Grimstad became the new Chairman and Chief Executive Officer of iPayment and Mark Monaco, iPayment’s Chief Financial Officer, became a member of iPayment’s and Holdings’ boards of directors. The Redemption Agreement includes covenants on the part of Mr. Daily not to compete with iPayment and its affiliates for one year, and not to solicit employees, independent sales agents and independent sales organizations and merchants of iPayment and its affiliates for three years, in each case from May 23, 2011, the closing date of the Equity Redemption.

The description set forth above is intended to be a summary only, is not complete and is qualified in its entirety by reference to the full and complete terms contained in the Redemption Agreement, a copy of which is included as Exhibit 99.1 to iPayment’s Current Report on Form 8-K filed with the Securities and Exchange Commission (the “SEC”) on April 13, 2011, which is incorporated herein by reference.

In accordance with ASC 805, the Company determined that a change of control occurred as a result of the Equity Redemption requiring assets and liabilities to be recorded at fair value. As part of the purchase accounting for the Equity Redemption for iPayment and its consolidated subsidiaries, approximately $273.7 million was assigned to merchant portfolios and other intangible assets and $669.6 million was assigned to goodwill. Of the amount assigned to merchant portfolios and other intangible assets, $205.8 million related to merchant portfolios, $65.5 million related to a trade name for iPayment and $2.4 million was primarily attributable to software development and other intangible assets. The aforementioned amounts resulted in increases over the historical basis prior to the Equity Redemption, of $132.6 million and $141.4 million in merchant portfolios and other intangible assets and goodwill, respectively. In addition, $32.7 million was assigned to deferred tax liabilities on the cumulative step-up of assets and liabilities that were adjusted to fair value using combined federal and state tax rates.

As part of the purchase accounting for the Equity Redemption for Holdings and its consolidated subsidiaries, approximately $273.7 million was assigned to merchant portfolios and other intangible assets and $670.4 million was assigned to goodwill. Of the amount assigned to merchant portfolios and other intangible assets, $205.8 million related to merchant portfolios, $65.5 million related to a trade name for iPayment and $2.4 million was primarily attributable to software development and other intangible assets. The aforementioned amounts resulted in increases over the historical basis prior to the Equity Redemption, of $132.6 million and $142.2 million in merchant portfolios and other intangible assets and goodwill, respectively. In addition, $32.7 million was assigned to deferred tax liabilities on the cumulative step-up of assets and liabilities that were adjusted to fair value using combined federal and state tax rates.

 

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Table of Contents

(4) Acquisitions

There were no acquisitions of businesses during the first three months of 2012 that were significant enough to require pro forma disclosure.

(5) Other Intangibles

Payments for Prepaid Residual Expenses

There were no payments for prepaid residual expenses during the three months ended March 31, 2012. During the three months ended March 31, 2011, we made payments totaling $0.5 million to several ISGs in exchange for contract modifications which lower our obligations for future payments of residuals to them. These payments have been assigned to intangible assets in the accompanying Consolidated Balance Sheets and are amortized over their expected useful lives.

(6) Long-Term Debt

Our long-term debt is comprised of the following:

 

      iPAYMENT, INC.     iPAYMENT HOLDINGS, INC.  

(Dollars in thousands)

   As of
March 31, 2012
    As of
December 31, 2011
    As of
March 31, 2012
    As of
December 31, 2011
 
     (unaudited)     (audited)     (unaudited)     (audited)  

Senior Secured Credit Facilities

        

Term facility

   $ 352,500      $ 360,500      $ 352,500      $ 360,500   

Revolving facility

     5,000        15,500        5,000        15,500   

Discount on Senior Secured Credit Facilities

     (1,648     (1,716     (1,648     (1,716

10.25% Notes

     400,000        400,000        400,000        400,000   

15.00%/15.00% Notes

     —          —          129,922        129,922   

Discount on 15.00%/15.00% Notes, net of amortization of $139 and $101 at March 31, 2012 and December 31, 2011, respectively

     —          —          (1,027     (1,065
  

 

 

   

 

 

   

 

 

   

 

 

 
     755,852        774,284        884,747        903,141   

Less: Current portion of long-term debt

     —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Total long-term debt

   $ 755,852      $ 774,284      $ 884,747      $ 903,141   
  

 

 

   

 

 

   

 

 

   

 

 

 

The terms of our long-term debt contain various nonfinancial and financial covenants as further discussed below. If we fail to comply with these covenants and are unable to obtain a waiver or amendment or otherwise cure the breach, an event of default would result. If an event of default were to occur, the trustee under the indentures governing the Notes or the lenders under the Senior Secured Credit Facilities could, among other things, declare outstanding amounts immediately due and payable. We currently do not have available cash and similar liquid resources available to repay all of our debt obligations if they were to become due and payable. As of March 31, 2012, our Senior Secured Leverage Ratio, as defined in the Senior Secured Credit Facilities, was 2.75 to 1.00 compared to the allowed maximum of 3.50 to 1.00. As of March 31, 2012, our Consolidated Interest Coverage Ratio, as defined in the Senior Secured Credit Facilities, was 2.19 to 1.00 compared to the allowed minimum of 1.40 to 1.00.

During the first three months of 2012, we made net repayments of $8.0 million on the term loan under the Senior Secured Credit Facilities and $10.5 million of net repayments on the revolving facility.

The shares of iPayment’s common stock held by Holdings have been pledged by Holdings to secure the obligations of iPayment under the Senior Secured Credit Facilities.

10.25% Notes

The 10.25% Notes were issued pursuant to an indenture, dated as of May 6, 2011 (the “10.25% Notes Indenture”), among the Company, the guarantors party thereto and Wilmington Trust, National Association (as successor by merger to Wilmington Trust FSB), as trustee (the “Trustee”). iPayment will pay interest on the 10.25% Notes in cash on November 15 and May 15 of each year at a rate of 10.25% per annum. Interest on the 10.25% Notes will accrue from and including the issue date of the 10.25% Notes The first interest payment date was November 15, 2011. The 10.25% Notes will mature on May 15, 2018. The 10.25% Notes Indenture

contains covenants that, among other things, restrict iPayment and its restricted subsidiaries’ ability to pay dividends, redeem stock or make other distributions or restricted payments, make certain investments, incur or guarantee additional indebtedness, create liens, agree to dividend and payment restrictions affecting restricted subsidiaries, consummate mergers, consolidations or other business combinations, designate subsidiaries as unrestricted, change its or their line of business, or enter into certain transactions with affiliates. The covenants in the 10.25% Notes Indenture generally permit iPayment to distribute funds to Holdings to make interest payments on the 15.00%/15.00% Notes to the extent required to be paid in cash by the terms of the 15.00%/15.00% Notes Indenture (as defined below) and for certain other operating expenses of Holdings.

The 10.25% Notes Indenture also provides for customary events of default including non-payment of principal, interest or premium, failure to comply with covenants, and certain bankruptcy or insolvency events.

 

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Table of Contents

Senior Secured Credit Facilities

iPayment also entered into a Credit Agreement, dated May 6, 2011 (the “Credit Agreement”), with Holdings, the subsidiaries of iPayment identified therein as guarantors, JPMorgan Chase Bank, N.A. and the other lenders party thereto. The Senior Secured Credit Facilities consist of (i) a six-year, $375.0 million term facility and (ii) a five-year, $75.0 million revolving facility, which includes a swing line loan facility and letter of credit facility and is available from time to time until the fifth anniversary of the closing date of the Senior Secured Credit Facilities (or in the case of the letter of credit facility, five business days prior to the fifth anniversary). The terms of the Senior Secured Credit Facilities give iPayment the ability, subject to certain conditions, to request an increase in the amount of the revolving facility in an aggregate amount of up to $25.0 million.

The interest rates under the Senior Secured Credit Facilities (other than in respect to swing line loans, which will accrue interest at the base rate described below) are calculated, at iPayment’s option, at either the Eurodollar rate (which is the higher of BBA LIBOR, and in respect of the term facility, 1.50%) or the base rate (which is the highest of JPMorgan Chase Bank, N.A.’s prime rate, the Federal Funds effective rate plus 0.50%, the one-month Eurodollar rate plus 1.00%, and in respect of the term facility, 2.50%) plus, in each case, the applicable margin which differs for the term facility and the revolving facility (and, which in the case of the revolving facility is subject to adjustment based on a pricing grid set forth in the Credit Agreement). Overdue principal, interest, fees and other amounts bear interest at a rate that is 2.00% above the rate then borne by such borrowing or the base rate in respect of the term facility, as applicable. iPayment also pays a quarterly commitment fee equal to 0.625% on the unused portion of the revolving facility which can decline to 0.375% of such unused portion based upon our consolidated leverage ratio as determined in accordance with the related pricing grid set forth in the Credit Agreement.

At March 31, 2012, iPayment had $350.9 million of term loans outstanding, net of discount of $1.6 million at a weighted average interest rate of 5.75% and $5.0 million of borrowings under its revolving facility at a weighted average interest rate of 4.50%.

The Credit Agreement contains certain customary covenants that, subject to certain exceptions, restrict iPayment and its subsidiaries’ ability to, among other things (i) declare dividends or redeem or repurchase equity interests by iPayment or its subsidiaries; (ii) prepay, redeem or purchase certain debt; (iii) incur liens and engage in sale-leaseback transactions; (iv) make loans and investments; (v) incur additional indebtedness; (vi) amend or modify specified debt and other material agreements; (vii) engage in mergers, acquisitions and asset sales; (viii) change accounting policies; (ix) become a general partner; (x) enter into speculative transactions; (xi) transact with affiliates; and (xii) engage in businesses that are not related to iPayment’s existing business. In addition, under the Credit Agreement, iPayment is required to comply (subject to a right to cure in certain circumstances) with specified financial ratios and tests, including a minimum consolidated interest coverage ratio and a maximum senior secured leverage ratio.

In addition, the Credit Agreement contains certain customary affirmative covenants, including requirements for financials reports and other notices from iPayment.

Events of default, which are subject to grace periods and exceptions, as set forth in the Credit Agreement include, among others: (i) iPayment’s failure to pay principal or interest or any other amount when due under the Credit Agreement; (ii) any representation or warranty proving to have been materially incorrect; (iii) covenant defaults; (iv) judgment defaults; (v) customary ERISA defaults; (vi) invalidity of loan documents or impairment of collateral; (vii) events of bankruptcy; (viii) a change of control; (ix) cross-default to material debt; and (x) cancellation or termination of a material contract, in certain circumstances.

15.00%/15.00% Notes

The 15.00%/15.00% Notes were issued pursuant to an indenture, dated as of May 6, 2011 (the “15.00%/15.00% Notes Indenture”), between Holdings and the Trustee. Interest on the 15.00%/15.00% Notes will accrue from and including the issue date of the 15.00%/15.00% Notes, and the first interest payment date was November 15, 2011. The 15.00%/15.00% Notes will mature on November 15, 2018. For any interest period through and including May 15, 2015, Holdings may elect to pay interest on the 15.00%/15.00% Notes (i) entirely in cash (“cash interest”) or (ii) pay interest on 50% of the outstanding principal amount of the 15.00%/15.00% Notes in cash interest and on 50% of the outstanding principal amount of the 15.00%/ 15.00% Notes by increasing the principal amount of the outstanding 15.00%/15.00% Notes or by issuing additional 15.00%/15.00% Notes (“PIK interest”). Notwithstanding the foregoing, Holdings will pay cash interest on the 15.00%/15.00% Notes to the extent that iPayment would, on the date notice of such election is required to be made, be permitted pursuant to its debt agreements to pay a dividend or distribution to Holdings in an amount sufficient to pay such cash interest on the relevant interest payment date. After May 15, 2015, Holdings will pay cash interest on the 15.00%/15.00% Notes, subject to certain rights to pay partial PIK interest for up to two additional interest periods.

Cash interest and PIK interest each accrue at a rate of 15.00% per annum. If Holdings’ leverage ratio exceeds 7.25 to 1.00 as of the most recent quarter end prior to an interest payment date, then for the interest period ending on such date, the interest rate will be retroactively increased by 2.00% in the form of PIK interest. The 15.00%/15.00% Notes will bear interest on the increased principal amount thereof from and after the applicable interest payment date on which a payment of PIK interest is made. Holdings must elect the form of interest payment with respect to each interest period not later than the beginning of each interest period. In the absence of such an election, Holdings will pay interest according to the election for the previous interest period. Interest for the first interest period will be paid 50% as cash interest and 50% as PIK interest.

 

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The 15.00%/15.00% Notes Indenture contains covenants that, among other things, restrict Holdings and its restricted subsidiaries’ ability to pay dividends, redeem stock or make other distributions or restricted payments, make certain investments, incur or guarantee additional indebtedness, create liens, agree to dividend and payment restrictions affecting restricted subsidiaries, consummate mergers, consolidations or other business combinations, designate subsidiaries as unrestricted, change its or their line of business, or enter into certain transactions with affiliates. The 15.00%/15.00% Notes Indenture also provides for customary events of default including non-payment of principal, interest or premium, failure to comply with covenants, and certain bankruptcy or insolvency events.

The 125,000 Units issued by Holdings on May 6, 2011, consists of $125.0 million in aggregate principal amount of 15.00%/15.00% Notes and Warrants to purchase 125,000 shares of common stock at $0.01 per share, subject to adjustment upon the occurrence of certain events described in the warrant agreement entered into by Holdings and Wilmington Trust, National Association (as successor by merger to Wilmington Trust FSB) (the “Warrant Agreement”). The proceeds from the issuance of the Units were allocated between the 15.00%/15.00% Notes and the Warrants based on the relative fair value of the items. The fair value of the Warrants was computed using the following assumptions:

 

     As of May 23, 2011  

Common stock at fair market value

   $ 9.43   

Exercise Price

   $ 0.01   

Term

     7.5 years   

Volatility

     42.68

Risk-free interest rate

     2.54

Dividend yield

     —     

The total proceeds from the issuance of the Units was $121.7 million, net of issuance costs of $3.3 million. The valuation resulted in $1.2 million of the gross proceeds being allocated to the Warrants and accordingly, was recorded as a debt discount as of May 23, 2011.

In accordance with the terms of the Warrant Agreement, the 15.00%/15.00% Notes and the Warrants separated on November 2, 2011, which is 180 days after the issue date of the Units. The Warrants are exercisable as of the opening of business on such date until 5:00 p.m., New York City time, on November 15, 2018. Each Warrant not exercised during such period will become void and all rights thereunder and all rights in respect thereof under the Warrant Agreement will cease as of such time.

The descriptions set forth in this Note 6 are intended to be summaries only, are not complete and are qualified in their entirety by reference to the full and complete terms contained in the 10.25% Notes Indenture (including the form of the notes attached thereto), the 15.00%/15.00% Notes Indenture (including the form of the notes attached thereto), the Credit Agreement and the Warrant Agreement. Copies of the 10.25% Notes Indenture and the Credit Agreement are included as Exhibits 4.1 and 10.1, respectively, to iPayment’s Current Report on Form 8-K filed with the SEC on May 12, 2011, and copies of the 15.00%/15.00% Notes Indenture and the Warrant Agreement are included as Exhibits 4.3 and 10.29, respectively, to the Company’s Registration Statement on Form S-4 filed with the SEC on October 11, 2011, which, in each case, are incorporated herein by reference.

iPayment and its consolidated subsidiaries had net capitalized debt issuance costs related to the Senior Secured Credit Facilities and 10.25% Notes of $10.0 million and $9.7 million, respectively, as of March 31, 2012. Holdings and its consolidated subsidiaries had net capitalized debt issuance costs related to the 15.00%/15.00% Notes of $3.1 million and a debt discount related to the Warrants of $1.0 million as of March 31, 2012.

These costs are being amortized to interest expense with amounts computed using an effective interest method over the life of the related debt instruments.

Amortization expense of iPayment and its consolidated subsidiaries related to the debt issuance costs for the Senior Secured Credit Facilities and the 10.25% Notes were $0.4 million and $0.3 million, respectively, for the three months ended March 31, 2012. Amortization expense of Holdings and its consolidated subsidiaries related to the debt issuance costs for the 15.00%/15.00% Notes was less than $0.1 million for the three months ended March 31, 2012.

The determination by the Boards of Directors of the Company and Holdings, at meetings held on November 1, 2012, that the Affected Financial Statements should no longer be relied upon resulted in a breach of certain representations, warranties and covenants set forth in the Senior Secured Credit Facilities, including but not limited to certain representations and warranties that the Affected Financial Statements (i) were prepared in accordance with GAAP consistently applied and (ii) fairly presented the financial condition of the Company and its subsidiaries as of the date thereof and their results of operations for the periods covered thereby in accordance with GAAP. Further, as a result of the decision to restate the Affected Financial Statements, we were unable to comply with the covenant set forth in the Senior Secured Credit Facilities that we deliver our 3rd Quarter 2012 financial statements by no later than November 14, 2012. Finally, as a result of the foregoing breaches and defaults, we were unable to satisfy the conditions precedent for borrowing

 

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under the Senior Secured Credit Facilities’ revolving credit facility in order to borrow the funds necessary to make the scheduled interest payments due on November 15, 2012 under the indentures related to the Company’s 10.25% Notes and Holdings’ 15.00%/15.00% Notes.

On November 14, 2012, we entered into a waiver, consent and amendment (the “Waiver”) with a majority of the lenders under the Senior Secured Credit Facilities. Among other things, the Waiver waives (a) defaults arising from the restatement of our financial statements (i) for the fiscal years ended December 31, 2008, 2009, 2010, and 2011 included in the Company’s Annual Reports on Form 10-K for the years then ended, (ii) for the interim periods within such fiscal years included in the Company’s Quarterly Reports on Form 10-Q and (iii) for the quarters ended March 31, 2012 and June 30, 2012 included in the Company’s Quarterly Reports on Form 10-Q and (b) until February 1, 2013, the Company’s failure to timely provide to the Administrative Agent its 3rd Quarter 2012 financial statements. Finally, under the terms of the Waiver, the revolving lenders under the Senior Secured Credit Facilities agreed that, absent any default thereunder that may occur after the date of the Waiver, each such revolving lender would continue to honor requests for borrowing under the Senior Secured Credit Facilities’ revolving credit facility, provided that the aggregate principal amount of all borrowings thereunder do not exceed $58 million, a reduction from $95 million, which represents the total revolving commitments under the Senior Secured Credit Facility. Such reduction in revolving commitments shall no longer be in effect upon the Company’s delivery, on or prior to February 1, 2013, of the restated financial statements and the Company’s unaudited financial statements (and related documentation) for the quarterly period ended September 30, 2012. Following receipt of the Waiver, the Company borrowed amounts under the Senior Secured Credit Facilities’ revolving credit facility so as to make the scheduled interest payments due on November 15, 2012 under the indentures related to the Company’s 10.25% Notes and Holdings’ 15.00%/15.00% Notes.

(7) Segment Information and Geographical Information

We consider our business activities to be in a single reporting segment, as we derive approximately 88% of our revenue and results of operations from processing revenues and other fees from electronic forms of payment. Substantially all revenues are generated in the United States.

(8) Income Taxes

We account for income taxes pursuant to the provisions of ASC 740 “Income Taxes.” Under this method, deferred tax assets and liabilities are recorded to reflect the future tax consequences attributable to the effects of differences between the carrying amounts of existing assets and liabilities for financial reporting and for income tax purposes.

As of March 31, 2012, we have net income taxes payable of $2.9 million and $3.2 million, for iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries, respectively.

We have an income tax benefit of $1.1 million and income tax expense of $2.0 million for iPayment and its consolidated subsidiaries and Holdings and its consolidated subsidiaries, respectively, during the first three months of 2012, in each case, compared to income tax expense of $4.4 million for the comparative period in 2011. Our full year forecasted effective tax rates are 44.9% for iPayment and its consolidated subsidiaries and (24.8%) for Holdings and its consolidated subsidiaries with the difference resulting from a portion of Holdings’ interest expense. The difference between the statutory federal rate of 34.0% and the 44.9% is attributable to disallowed expenses. We are subject to interest deductibility limitations with respect to interest accruing on the 15.00%/15.00% Notes, which constitute an “Applicable High Yield Discount Obligation” for U.S. federal income tax purposes. Consequently, a portion of the interest expense under the 15.00%/15.00% Notes is non-deductible by Holdings.

During the first three months of 2012 and 2011, we accrued less than $0.1 million of interest related to our uncertain tax positions. As of March 31, 2012, our liabilities for unrecognized tax benefits totaled $1.4 million and are included in other long-term liabilities in our consolidated balance sheets. Interest and penalties related to income tax liabilities are included in income tax expense. The balance of accrued interest and penalties recorded in the consolidated balance sheets at March 31, 2012 was approximately $0.3 million.

We file federal income tax returns and various state income tax returns. With limited exception, we are no longer subject to federal, state and local income tax audits by taxing authorities for the years prior to 2007.

At March 31, 2012, Holdings had federal and state net operating loss carryforwards of approximately $3.5 million and $67.2 million, respectively. Holdings’ federal net operating loss carryforward begins to expire in 2021 and is subject to annual limitations under Section 382 of the Internal Revenue Code. Holdings’ various state net operating loss carryforwards begin to expire between 2016 through 2027 several of which are also subject to annual limitations.

 

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(9) Commitments and Contingencies

Legal Proceedings

We are party to certain legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the ultimate outcome of these matters cannot be predicted with certainty, based on information currently available, advice of counsel, and available insurance coverage, we do not believe that the outcome of any of these claims will have a material adverse effect on our business, financial condition or results of operations. However, the results of legal proceedings cannot be predicted with certainty, and in the event of unexpected future developments the ultimate resolution of one or more of these matters could be unfavorable. Should we fail to prevail in any of these legal matters or should several of these legal matters be resolved against us in the same reporting period, our consolidated financial position or operating results could be materially adversely affected. Regardless of the outcome, any litigation may require us to incur significant litigation expenses and may result in significant diversion of management’s attention. All litigation settlements are recorded within “other expense” on our consolidated statements of operations.

 

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(10) Recent Accounting Pronouncements

In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The provisions of ASU No. 2011-04 result in a consistent definition of fair value and common requirements for the measurement of and disclosure about fair value between U.S. GAAP and International Financial Reporting Standards (“IFRS”). The changes to U.S. GAAP as a result of ASU No. 2011-04 are as follows: (1) The concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets (that is, it does not apply to financial assets or any liabilities); (2) U.S. GAAP currently prohibits application of a blockage factor in valuing financial instruments with quoted prices in active markets. ASU No. 2011-04 extends that prohibition to all fair value measurements; (3) An exception is provided to the basic fair value measurement principles for an entity that holds a group of financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk that are managed on the basis of the entity’s net exposure to either of those risks. This exception allows the entity, if certain criteria are met, to measure the fair value of the net asset or liability position in a manner consistent with how market participants would price the net risk position; (4) Aligns the fair value measurement of instruments classified within an entity’s shareholders’ equity with the guidance for liabilities; and (5) Disclosure requirements have been enhanced for Level 3 fair value measurements to disclose quantitative information about unobservable inputs and assumptions used, to describe the valuation processes used by the entity, and to qualitatively describe the sensitivity of fair value measurements to changes in unobservable inputs and the interrelationships between those inputs. In addition, entities must report the level in the fair value hierarchy of items that are not measured at fair value in the statement of condition but whose fair value must be disclosed. The Company adopted the provisions of ASU No. 2011-04 effective January 1, 2012. The fair value measurement provisions of ASU No. 2011-04 had no impact on the Company’s consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” The provisions of ASU No. 2011-05 allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. Under either method, entities are required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. ASU No. 2011-05 also eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU No. 2011-05 was effective for the Company’s interim reporting period beginning on or after January 1, 2012, with retrospective application required. In December 2011, the FASB issued ASU No. 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” The provisions of ASU No. 2011-12 defer indefinitely the requirement for entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. ASU No. 2011-12, which shares the same effective date as ASU No. 2011-05, does not defer the requirement for entities to present components of comprehensive income in either a single continuous statement of comprehensive income or in two separate but consecutive statements. The Company adopted the provisions of ASU No. 2011-05 and ASU No. 2011-12 which resulted in a new statement of comprehensive income for the interim period ended March 31, 2012.

(11) Related Party Transactions

In November 2010, we entered into a sublease agreement with Fortis Payment Systems, LLC, an ISG owned by an iPayment employee, through Cambridge Acquisition Sub, LLC, a wholly owned subsidiary. The lease agreement extends through 2013, with an option of extending the contract through 2015. The lease agreement provides for minimum annual payments of $60,000 beginning November 2010 for three years.

In 2010, iPayment and the financial services firm Perella Weinberg Partners LP (“Perella Weinberg”) entered into an engagement letter providing for Perella Weinberg to act as our financial advisor in connection with a potential change of control or similar transaction involving the Company. In March 2010, Adaero Holdings, LLC (“Adaero”), an entity majority owned and controlled by Mark Monaco, entered into a consulting agreement with Perella Weinberg. Mr. Monaco became Chief Financial Officer of iPayment in October 2010 and a member of the boards of directors of iPayment and Holdings following the Refinancing. When the Equity Redemption was consummated, we paid to Perella Weinberg a transaction fee of approximately $7.5 million pursuant to such engagement letter and, following such payment, Perella Weinberg made a payment of $1.0 million to Adaero pursuant to the consulting agreement described above.

 

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(12) Subsequent Events

Senior Secured Credit Facilities Waiver, Consent and Amendment

On November 14, 2012, we entered into a waiver, consent and amendment (the “Waiver”) with a majority of the lenders under the Senior Secured Credit Facilities. Among other things, the Waiver waives (a) defaults arising from the restatement of our financial statements (i) for the fiscal years ended December 31, 2008, 2009, 2010, and 2011 included in the Company’s Annual Reports on Form 10-K for the years then ended, (ii) for the interim periods within such fiscal years included in the Company’s Quarterly Reports on Form 10-Q and (iii) for the quarters ended March 31, 2012 and June 30, 2012 included in the Company’s Quarterly Reports on Form 10-Q and (b) until February 1, 2013, the Company’s failure to timely provide to the administrative agent for the Senior Secured Credit Facilities the Company’s financial statements for the quarterly period ended September 30, 2012. Finally, under the terms of the Waiver, the revolving lenders under the Senior Secured Credit Facilities agreed that, absent any default thereunder that may occur after the date of the Waiver, each such revolving lender would continue to honor requests for borrowing under the Senior Secured Credit Facilities’ revolving credit facility, provided that the aggregate principal amount of all borrowings thereunder do not exceed $58 million , a reduction from $95 million, which represents the total revolving commitments under the Senior Secured Credit Facility. Such reduction in revolving commitments shall no longer be in effect upon the Company’s delivery, on or prior to February 1, 2013, of the restated financial statements and the Company’s unaudited financial statements (and related documentation) for the quarterly period ended September 30, 2012.

Following receipt of the Waiver, the Company borrowed amounts under the Senior Secured Credit Facilities’ revolving credit facility so as to make the scheduled interest payments due on November 15, 2012 under the indentures related to the Company’s 10.25% Notes and Holdings’ 15.00%/15.00% Notes.

15.00%/15.00% Notes Purchase

On July 20, 2012, iPayment purchased approximately $23.9 million principal amount of the 15.00%/15.00% Notes from a third party in a privately negotiated transaction. The purchase of such 15.00%/15.00% Notes and the expenses associated therewith were funded with cash on hand and borrowings under the revolving facility under the Senior Secured Credit Facilities. Concurrent with the purchase of such 15.00%/15.00% Notes, we requested and obtained a $20 million increase in the aggregate revolving facility commitment under the Senior Secured Credit Facility. The aggregate commitment of the lenders under the revolving facility following such increase was $95 million. On November 14, 2012, as discussed above, we entered into the Waiver which reduced the revolving commitments from $95 million to $58 million.

Flagship Merchant Services Purchase Agreement

On May 2, 2012, we entered into a definitive asset purchase agreement with CardServ, Inc., a Massachusetts corporation doing business as Flagship Merchant Services (“Flagship”). On May 23, 2012, pursuant to the definitive agreement, one of our wholly owned subsidiaries purchased substantially all of the assets of Flagship for a purchase price of approximately $14 million. We funded the acquisition of Flagship through revolver borrowings and cash on hand. Flagship is an independent sales organization with headquarters in Charlestown, Massachusetts.

Other Acquisitions

In April 2012, we entered into a purchase and sale agreement with an existing ISG, whereby we acquired a portfolio of merchant accounts. Consideration at closing was $2.5 million in cash, which was funded at closing from borrowings under our revolving facility. The effect of the portfolio acquisition was included in our consolidated financial statements beginning April 1, 2012.

In April 2012, we entered into a second purchase and sale agreement with an existing ISG, whereby we acquired a portfolio of merchant accounts. Consideration at closing was $2.6 million in cash, which was funded at closing from borrowings under our revolving facility. The effect of the portfolio acquisition was included in our consolidated financial statements beginning April 1, 2012.

In December 2012, we entered into a purchase and sale agreement with an existing ISG, whereby we acquired a portfolio of merchant accounts. Consideration at closing was $8.0 million in cash, which was funded at closing with cash on hand. The effect of the portfolio acquisition will be included in our consolidated financial statements beginning January 1, 2013.

Adoption of Equity Incentive Plan

On August 27, 2012, the Board of Directors (the “Board”) of Holdings adopted the iPayment Holdings, Inc. Equity Incentive Plan (the “Plan”). The purpose of the Plan is to foster and promote the long-term financial success of Holdings by rewarding executives and key employees of Holdings and its subsidiaries who contribute to Holdings’ profitability and productivity. No awards were granted under the Plan until November 15, 2012.

 

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Grants of Phantom Units

On November 15, 2012, the Board granted 324,074.07 phantom units under the Plan to Mark C. Monaco and entered into a phantom unit agreement with Mr. Monaco. Under the phantom unit agreement, 50% of phantom units are “service units” and the remaining 50% of the phantom units are “performance units.” Service units are 20% vested at the time of the grant, with the remaining service units vesting in equal increments on the first four anniversaries of the grant date. Performance units vest, if at all, upon the earlier of a change in control or a public offering. If neither a change in control nor a public offering has occurred by the seventh anniversary of the grant date, all unvested performance units will be forfeited. In addition, the phantom unit agreement also provides that service units will become fully vested upon a change in control and all performance units will vest or be forfeited in accordance with the performance criteria described above.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

As discussed in the Explanatory Note and in Note 2 to our consolidated financial statements “Restatement of Consolidated Financial Statements,” which accompanies the unaudited financial statements in Item 1 of this report, we are amending and restating our unaudited financial statements and related disclosures for all periods presented in this Amended Filing. The following discussion and analysis of our financial condition and results of operations incorporates the restated amounts. For this reason, the data set forth in this section may not be comparable to discussion and data in the Original Filing.

The following discussion should be read in conjunction with our financial statements and the notes thereto. Some of our discussion is forward-looking and involves risks and uncertainties. For information regarding risk factors that could have a material adverse effect on our business and results of operations, refer to the section in our Amended 2011 Annual Report entitled “Risk Factors.”

Executive Overview

We are a provider of credit and debit card payment processing services to small merchants across the United States. During March 2012, we generated revenue from approximately 186,000 merchants. Of these merchants, approximately 130,000 were active merchants that had each processed at least one Visa or MasterCard transaction during that month. Our payment processing services enable our merchants to accept credit cards as well as other forms of payment, including debit cards, checks, gift cards and loyalty programs in traditional card-present, or swipe transactions, as well as card-not-present transactions, such as those done over the phone or through the internet. We market and sell our services primarily through independent sales groups, or “ISGs,” which are non-employee, external sales organizations and other third party resellers of our products and services. We also market our services directly to merchants through electronic media, telemarketing and other programs, including utilizing partnerships with other companies that market products and services to small businesses. In addition, we partner with banks such as Wells Fargo to sponsor us for membership in the Visa, MasterCard or other card associations and to settle transactions with merchants. We perform core functions for small merchants such as application processing, underwriting, account set-up, risk management, fraud detection, merchant assistance and support, equipment deployment, and chargeback services, primarily in our main operating center in Westlake Village, California.

Our strategy is to increase profits by increasing our penetration of the small merchant marketplace for payment services. Our charge volume increased 2.8% to $5,538 million for the three months ended March 31, 2012 from $5,385 million for the three months ended March 31, 2011. This increase in charge volume was due primarily to a higher number of transactions per merchant in the first three months of 2012 compared to 2011. However, our revenues decreased $4.5 million or 2.6% to $165.1 million in the first three months of 2012 from $169.6 million in the same period in 2011. The decrease in revenues was primarily due to a reduction in the average discount rate charged to merchants as a percentage of merchant processing volume, driven in large part by the impact from the Durbin Amendment to the Dodd-Frank Act (the “Durbin Amendment”) that became effective on October 1, 2011. Our net revenue increased 7.9% to $72.4 million for the three months ended March 31, 2012, from $67.1 million during the same period in 2011. Our net revenue is composed of total revenue reduced by interchange fees and network fees. Income from operations decreased 34.6% to $13.1 million for the three months ended March 31, 2012, from $20.1 million during the same period in 2011. The decline in income from operations was primarily due to increases in depreciation and amortization as a result of the Equity Redemption and resulting change of control. Loss before income taxes was $2.7 million for iPayment and its consolidated subsidiaries and $7.7 million for Holdings and its consolidated subsidiaries during the three months ended March 31, 2012, in each case, compared to $12.2 million of income before income taxes in the same period in 2011.

In May 2011, we consummated refinancing transactions, which we collectively refer to as the “Refinancing,” and a redemption, which we refer to as the “Equity Redemption,” of all of the direct and indirect equity interests in us and our affiliates held by Gregory Daily, iPayment’s former Chairman and Chief Executive Officer, and certain persons and entities affiliated with or controlled by him. Please refer to Notes 1, 3 and 6 of the accompanying consolidated financial statements for a description of the Equity Redemption and the Refinancing, which is incorporated herein by reference.

 

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Critical Accounting Policies

The accompanying consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”), which require that management make numerous estimates and assumptions. Actual results could differ from those estimates and assumptions, impacting our reported results of operations and financial position. The critical accounting policies described here are those that are most important to the depiction of our financial condition and results of operations and their application requires management’s most subjective judgment in making estimates about the effect of matters that are inherently uncertain.

Accounting for Goodwill and Intangible Assets. We follow ASC 350 “Intangibles — Goodwill and Other Topics,” which addresses financial accounting and reporting for acquired goodwill and other intangible assets, and requires that goodwill is subject to at least an annual assessment for impairment. If facts and circumstances indicate goodwill may be impaired, we perform a recoverability evaluation. In accordance with ASC 350, the recoverability analysis is based on fair value. The calculation of fair value includes a number of estimates and assumptions, including projections of future income and cash flows, the identification of appropriate market multiples and the choice of an appropriate discount rate.

We engage, on a regular basis, an independent third party to aid management in determining the fair value of our goodwill. We also periodically evaluate the carrying value of long-lived assets in relation to the respective projected future undiscounted cash flows to assess recoverability. An impairment loss is recognized if the sum of the expected net cash flows is less than the carrying amount of the long-lived assets being evaluated. The difference between the carrying amount of the long-lived assets being evaluated and their fair value, calculated as the sum of the expected cash flows discounted at a market rate, represents the impairment loss.

Purchased merchant processing portfolios are recorded at cost and are evaluated by management for impairment at the end of each fiscal quarter through review of actual attrition and cash flows generated by the portfolios in relation to the expected attrition and cash flows and the recorded amortization expense. Amortization of intangible assets results from our acquisitions of portfolios of merchant contracts, revenue streams related to residual agreements related to merchant portfolios, or residual buyouts or acquisitions of a business where we allocated a portion of the purchase price to the existing merchant processing portfolios and other intangible assets. The estimated useful lives of our merchant processing portfolios are assessed by evaluating each portfolio to ensure that the recognition of the costs of revenues, represented by amortization of the intangible assets, approximate the distribution of the expected revenues from each processing portfolio. If, upon review, actual attrition and cash flows indicate impairment of the value of the merchant processing portfolios, an impairment loss would be recognized. Historically, we have experienced monthly volume attrition ranging from 1.5% to 2.5% of our total charge volume on our various merchant portfolios. We utilize an accelerated method of amortization over a 15-year period, which we believe approximates the distribution of actual cash flows generated by our merchant processing portfolios. All other intangible assets are amortized using the straight-line method over an estimated life of three to seven years.

In addition, we have implemented both quarterly and annual procedures to determine whether a significant change in the trend of the current attrition rates being used has occurred on a portfolio-by-portfolio basis. In reviewing the current attrition rate trends, we consider relevant benchmarks such as charge volume, revenues, number of merchant accounts, gross profit and future expectations of the aforementioned factors compared to historical amounts and rates. If we identify any significant changes or trends in the attrition rate of any portfolio, we will adjust our current and prospective estimated attrition rates so that the amortization expense better approximates the distribution of actual cash flows generated by the merchant processing portfolios. Any adjustments made to the amortization schedules would be reported in our current consolidated statements of operations and comprehensive income (loss) and on a prospective basis until further evidence becomes apparent.

As a result of the Equity Redemption, we have determined the fair value of our intangible assets and goodwill in accordance with ASC 805, and we engaged an independent, third party valuation firm to assist in evaluating the fair value of certain assets as of May 23, 2011.

Revenue and Cost Recognition. Substantially all of our revenues are generated from fees charged to merchants for payment processing services. We typically charge these merchants a rate, primarily based upon each merchant’s monthly charge volume and risk profile. Our fees principally consist of discount fees, which are a percentage of the dollar amount of each credit or debit transaction. We charge merchants higher discount rates for card-not-present transactions than for card-present transactions in order to provide compensation for the higher risk of underwriting these transactions. We derive the balance of our revenues from a variety of fixed transaction or service fees, including fees for monthly minimum charge volume requirements, statement fees, annual fees, payment card industry compliance fees, ancillary products, and fees for other miscellaneous services, such as handling chargebacks. We recognize discounts and other fees related to payment transactions at the time a merchant’s transactions are processed. Related interchange and assessment costs are also recognized at that time. We recognize revenues derived from service fees at the time the service is performed.

We follow the requirements included in the Revenue Recognition Topic of ASC 605 “Reporting Revenue Gross as a Principal Versus Net as an Agent.” Generally, where we have ownership of the merchant agreement, credit risk and ultimate responsibility for the merchant, revenues are reported at the time of sale on a gross basis equal to the full amount of the discount charged to the merchant. This amount includes interchange paid to card issuing banks and assessments paid to payment card associations pursuant to which such parties receive payments based primarily on processing volume for particular groups of merchants. Interchange fees are recognized at the time transactions are processed. Revenues generated from certain bank portfolios acquired from First Data Merchant Services Corporation and other sources are reported net of interchange, as required by ASC Topic 605, because we may not have credit risk, portability or the ultimate responsibility for the merchant accounts.

 

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The most significant component of operating expenses is interchange fees, which are amounts we pay to the card issuing banks. Interchange fees are primarily based on transaction processing volume, except in the case of regulated debit transactions, where they are based primarily on a per transaction basis and are recognized at the time transactions are processed.

Other costs of services includes costs directly attributable to our provision of payment processing and related services to our merchants and primarily includes residual payments to ISGs, which are commissions we pay to our ISGs based upon a percentage of the net revenues we generate from their merchant referrals, and assessment fees payable to card associations, which are a percentage of the charge volume we generate from Visa and MasterCard. In addition, other costs of services includes telecommunications costs, personnel costs, occupancy costs, losses due to merchant defaults, other miscellaneous merchant supplies and services expenses, bank sponsorship costs and other third-party processing costs. Other costs of services also includes depreciation expense, which is recognized on a straight-line basis over the estimated useful life of the assets, and amortization expense, which is recognized using an accelerated method over a fifteen-year period. Amortization of intangible assets results from our acquisitions of portfolios of merchant contracts, revenue streams related to residual agreements related to merchant portfolios, or residual buyouts or acquisitions of a business where we allocated a portion of the purchase price to the existing merchant processing portfolios and other intangible assets.

Selling, general and administrative expenses consists primarily of salaries and wages, as well as other general administrative expenses such as marketing expenses and professional fees.

Reserve for Merchant Losses. Disputes between a cardholder and a merchant periodically arise as a result of, among other things, cardholder dissatisfaction with merchandise quality or merchant services. Such disputes may not be resolved in the merchant’s favor. In these cases, the transaction is “charged back” to the merchant, which means the purchase price is refunded to the customer through the merchant’s acquiring bank and charged to the merchant. If the merchant has inadequate funds, we or, under limited circumstances, the acquiring bank and us, must bear the credit risk for the full amount of the transaction. We evaluate the merchant’s risk for such transactions and estimate its potential loss for chargebacks based primarily on historical experience and other relevant factors and record a loss reserve accordingly. At March 31, 2012, and December 31, 2011, our reserve for losses on merchant accounts included in accrued liabilities and other totaled $1.3 million and $1.2 million, respectively. We believe our reserve for charge-back and other similar processing-related merchant losses is adequate to cover both the known probable losses and the incurred but not yet reported losses at March 31, 2012, and December 31, 2011.

Income Taxes. We account for income taxes pursuant to the provisions of ASC 740 “Income Taxes.” Under this method, deferred tax assets and liabilities are recorded to reflect the future tax consequences attributable to the effects of differences between the carrying amounts of existing assets and liabilities for financial reporting and for income tax purposes.

Seasonality

Our revenues and earnings are impacted by the volume of consumer usage of credit and debit cards at the point of sale. For example, we experience increased point of sale activity during the traditional holiday shopping period in the fourth quarter. Revenues during the first quarter tend to decrease in comparison to the remaining three quarters of our fiscal year on a same store basis, particularly in comparison to our fourth quarter.

Off-Balance Sheet Arrangements

We do not have transactions, arrangements and other relationships with unconsolidated entities that are reasonably likely to affect our liquidity or capital resources. We have no special purpose or limited purpose entities that provide off-balance sheet financing, liquidity or market or credit risk support, engage in leasing, hedging, research and development services, or other relationships that expose us to liability that is not reflected on the face of the financial statements.

Results of Operations

As a result of the Equity Redemption, our results of operations, financial position and cash flows prior to the date of the Equity Redemption are presented as the “Predecessor.” The financial effects of the Equity Redemption and our results of operations, financial position and cash flows following the Equity Redemption are presented as the “Successor.” Accordingly, as used in this Quarterly Report, the terms “first three months of 2012” and “three months ended March 31, 2012,” refer to the results of the Successor entities and the terms “first three months of 2011” and “three months ended March 31, 2011,” refer to the results of the Predecessor entities for such periods.

 

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Three Months Ended March 31, 2012, Compared to Three Months Ended March 31, 2011

 

     Three months ended March 31,     Change  

(Dollars in thousands, except percentages)

   2012
(Restated)
    % of Total
Revenue
    2011
(Restated)
    % of Total
Revenue
    Amount     %  

Revenues

   $ 165,132        100.0   $ 169,613        100.0   $ (4,481     (2.6 )% 

Operating expenses

            

Interchange

     81,858        49.6        90,728        53.5        (8,870     (9.8

Other costs of services (1)

     65,013        39.4        54,164        31.9        10,849        20.0   

Selling, general and administrative (2)

     4,232        2.6        4,290        2.5        (58     (1.4

Embezzlement costs

     922        0.6        375        0.2        547        145.9   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total operating expenses (3)

     152,025        92.2        149,557        88.1        2,468        1.7   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income from operations

     13,107        7.8        20,056        11.9        (6,949     (34.6

Other expense

            

Interest expense, net (4)

     16,386        9.9        7,901        4.7        8,485        107.4   

Other (income), net

     (581     (0.4     (30     —          (551     1,836.7   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total other expense (5)

     15,805        9.5        7,871        4.7        7,934        100.8   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income (loss) before income taxes (6)

     (2,698     (1.7     12,185        7.2        (14,883     (122.1

Income tax provision (benefit) (7)

     (1,097     (0.7     4,421        2.6        (5,518     (124.8
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income (loss) (8)

   $ (1,601     (1.0 )%    $ 7,764        4.6   $ (9,365     (120.6 )% 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Other costs of services of Holdings and its consolidated subsidiaries for the three months ended March 31, 2012, is $65.0 million.
(2) Selling, general and administrative expenses of Holdings and its consolidated subsidiaries for the three months ended March 31, 2012, is $4.3 million.
(3) Total operating expenses of Holdings and its consolidated subsidiaries for the three months ended March 31, 2012, is $152.1 million.
(4) Net interest expense of Holdings and its consolidated subsidiaries for the three months ended March 31, 2012, is $21.4 million.
(5) Total other expense of Holdings and its consolidated subsidiaries for the three months ended March 31, 2012, is $20.8 million.
(6) Loss before income taxes of Holdings and its consolidated subsidiaries for the three months ended March 31, 2012, is $7.7 million
(7) Income tax expense of Holdings and its consolidated subsidiaries for the three months ended March 31, 2012, is $2.0 million.
(8) Net loss of Holdings and its consolidated subsidiaries for the three months ended March 31, 2012, is $9.8 million.

Revenues. Revenues decreased 2.6% to $165.1 million in the first three months of 2012 from $169.6 million during the same period in 2011. The decrease in revenues was primarily due to a reduction in the average discount rate charged to merchants as a percentage of merchant processing volume, driven in large part by the impact from the Durbin Amendment to the Dodd-Frank Act which regulates interchange levels for certain debt transactions. Merchant processing volume, which represents the total value of transactions processed by us, increased by 2.8%, to $5,538 million during the first three months of 2012 from $5,385 million during the same period in 2011.

Interchange Expenses. Interchange expenses decreased 9.8% to $81.9 million in the first three months of 2012 from $90.7 million during the same period in 2011. Interchange expenses decreased due to a reduction in the average interchange rate as a percentage of merchant processing volume, driven in large part by changes in debit card interchange rates that card issuing banks may charge as a result of the Durbin Amendment

Other Costs of Services. Other costs of services increased 20.0% to $65.0 million for iPayment and its consolidated subsidiaries in the first three months of 2012 from $54.2 million during the same period in 2011. Other costs of services increased 19.9% to $65.0 million for Holdings and its consolidated subsidiaries in the first three months of 2012 from $54.2 million during the same period in 2011. The increase in other costs of services was primarily due to higher sales expenses and amortization expenses as a result of the application of ASC 805 in May 2011.

Selling, General and Administrative. Selling, general and administrative expenses decreased 1.4% to $4.2 million for iPayment and its consolidated subsidiaries in the first three months of 2012 as compared to $4.3 million during the same period in 2011. Selling, general and administrative expenses decreased 0.9% to $4.3 million for Holdings and its consolidated subsidiaries in the first three months of 2012.

Other Expense. Total other expense increased $7.9 million for iPayment and its consolidated subsidiaries and $12.9 million for Holdings and its consolidated subsidiaries in the first three months of 2012, in each case, from $7.9 million during the same period in 2011. Interest expense, the primary component of total other expense, increased $8.5 million for iPayment and its consolidated subsidiaries and $13.5 million for Holdings and its consolidated subsidiaries in the first three months of 2012 from $7.9 million in each case during the same period in 2011, largely due to a higher average debt balance as a result of the Refinancing (see Note 3 to the consolidated financial statements) as well as a higher weighted average interest rate.

Income Tax. We have an income tax benefit of $1.1 million and income tax expense of $2.0 million for iPayment and its consolidated

 

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subsidiaries and Holdings and its consolidated subsidiaries, respectively, during the first three months of 2012, in each case, compared to income tax expense of $4.4 million for the comparative period in 2011. Our full year forecasted effective tax rates are 44.9% for iPayment and its consolidated subsidiaries and (24.8%) for Holdings and its consolidated subsidiaries with the difference resulting from a portion of Holdings’ interest expense. The difference between the statutory federal rate of 34.0% and the 44.9% is attributable to disallowed expenses. We are subject to interest deductibility limitations with respect to interest accruing on the 15.00%/15.00% Notes, which constitute an “Applicable High Yield Discount Obligation” for U.S. federal income tax purposes. Consequently, a portion of the interest expense under the 15.00%/15.00% Notes is non-deductible by Holdings.

Liquidity and Capital Resources

As of March 31, 2012, and December 31, 2011, we had cash and cash equivalents of approximately $0.2 million and less than $0.1 million, respectively. We usually minimize cash balances in order to minimize borrowings and, therefore, interest expense. As of March 31, 2012, iPayment and its consolidated subsidiaries had a net working capital deficit (current liabilities in excess of current assets) of $6.6 million compared to a net deficit of $2.2 million as of December 31, 2011. The net deficit increase resulted primarily from a reduction in accounts receivable of $1.0 million and an increase in accrued interest of $10.2 million, offset by an increase in cash and cash equivalents of $0.2 million, a reduction in accrued liabilities and other of $0.4 million, and reductions in accounts payable and income taxes payable of $2.4 million and $3.7 million, respectively.

As of March 31, 2012, Holdings and its consolidated subsidiaries had a net working capital deficit of $14.3 million compared to a net working capital deficit of $1.9 million as of December 31, 2011. The working capital deficit increase resulted primarily from a reduction in accounts receivable of $1.0 million and an increase in accrued interest of $15.1 million, offset by an increase in cash and cash equivalents of $0.2 million, a reduction in accrued liabilities and other of $0.3 million, and reductions in accounts payable and income taxes payable of $2.4 million and $0.6 million, respectively.

We expect that our cash flow from operations and proceeds from borrowings under our revolving facility will be our primary sources of liquidity and will be sufficient to fund our cash requirements for at least the next twelve months. See “Contractual Obligations” below for a description of future required uses of cash.

We have significant outstanding long-term debt as of March 31, 2012. The terms of our long-term debt contain various nonfinancial and financial covenants as further discussed in Note 6 to the consolidated financial statements. If we fail to comply with these covenants and are unable to obtain a waiver or amendment or otherwise cure the breach, an event of default would result. If an event of default were to occur, the trustee under the indentures governing the Notes or the lenders under the Senior Secured Credit Facilities could, among other things, declare outstanding amounts immediately due and payable. We currently do not have available cash and similar liquid resources available to repay all of our debt obligations if they were to become due and payable. As of March 31, 2012, our Senior Secured Leverage Ratio, as defined in the Senior Secured Credit Facilities, was 2.75 to 1.00 compared to the allowed maximum of 3.50 to 1.00. As of March 31, 2012, our Consolidated Interest Coverage Ratio, as defined in the Senior Secured Credit Facilities, was 2.19 to 1.00 compared to the allowed minimum of 1.40 to 1.00.

If we do not generate sufficient cash flow from operations to satisfy our debt obligations, including interest payments and the payment of principal at maturity, we may have to undertake alternative financing plans, such as refinancing or restructuring our debt, selling assets, reducing or delaying capital investments or seeking to raise additional capital. We cannot be sure that any refinancing or sale of assets would be possible on commercially reasonable terms or at all. In addition, any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous covenants, which could further restrict our business operations.

The determination by the Boards of Directors of the Company and Holdings, at meetings held on November 1, 2012, that the Affected Financial Statements should no longer be relied upon resulted in a breach of certain representations, warranties and covenants set forth in the Senior Secured Credit Facilities, including but not limited to certain representations and warranties that the Affected Financial Statements (i) were prepared in accordance with GAAP consistently applied and (ii) fairly presented the financial condition of the Company and its subsidiaries as of the date thereof and their results of operations for the periods covered thereby in accordance with GAAP. Further, as a result of the decision to restate the Affected Financial Statements, we were unable to comply with the covenant set forth in the Senior Secured Credit Facilities that we deliver our 3rd Quarter 2012 financial statements by no later than November 14, 2012. Finally, as a result of the foregoing breaches and defaults, we were unable to satisfy the conditions precedent for borrowing under the Senior Secured Credit Facilities’ revolving credit facility in order to borrow the funds necessary to make the scheduled interest payments due on November 15, 2012 under the indentures related to the Company’s 10.25% Notes and Holdings’ 15.00%/15.00% Notes.

On November 14, 2012, we entered into a waiver, consent and amendment (the “Waiver”) with a majority of the lenders under the Senior Secured Credit Facilities. Among other things, the Waiver waives (a) defaults arising from the restatement of our financial statements (i) for the fiscal years ended December 31, 2008, 2009, 2010, and 2011 included in the Company’s Annual Reports on Form 10-K for the years then ended, (ii) for the interim periods within such fiscal years included in the Company’s Quarterly Reports on Form 10-Q and (iii) for the quarters ended March 31, 2012 and June 30, 2012 included in the Company’s Quarterly Reports on Form 10-Q and (b) until February 1, 2013, the Company’s failure to timely provide to the Administrative Agent its 3rd Quarter 2012

 

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financial statements. Finally, under the terms of the Waiver, the revolving lenders under the Senior Secured Credit Facilities agreed that, absent any default thereunder that may occur after the date of the Waiver, each such revolving lender would continue to honor requests for borrowing under the Senior Secured Credit Facilities’ revolving credit facility, provided that the aggregate principal amount of all borrowings thereunder do not exceed $58 million, a reduction from $95 million, which represents the total revolving commitments under the Senior Secured Credit Facility. Such reduction in revolving commitments shall no longer be in effect upon the Company’s delivery, on or prior to February 1, 2013, of the restated financial statements and the Company’s unaudited financial statements (and related documentation) for the quarterly period ended September 30, 2012. Following receipt of the Waiver, the Company borrowed amounts under the Senior Secured Credit Facilities’ revolving credit facility so as to make the scheduled interest payments due on November 15, 2012 under the indentures related to the Company’s 10.25% Notes and Holdings’ 15.00%/15.00% Notes.

Operating activities

Net cash provided by operating activities was $20.1 million during the first three months of 2012. For iPayment and its consolidated subsidiaries, net cash provided by operating activities consisted of net loss of $1.6 million adjusted by depreciation and amortization of $16.6 million, non-cash interest expense and other of $0.8 million, loss on disposal of property and equipment of $0.4 million, and a net favorable change in operating assets and liabilities of $4.0 million primarily due to an increase in accrued interest offset by decreases in accounts payable and income taxes payable as a result of federal and state tax payments made during 2012. For Holdings and its consolidated subsidiaries, net cash provided by operating activities consisted of a net loss of $9.8 million adjusted by depreciation and amortization of $16.6 million, non-cash interest expense and other of $3.3 million, loss on disposal of property and equipment of $0.4 million, and a net favorable change in operating assets and liabilities of $9.7 million primarily due to an increase in accrued interest offset by decreases in accounts payable and income taxes payable as a result of federal and state tax payments made during 2012.

Net cash provided by operating activities was $12.8 million during the first three months of 2011, consisting of net income of $7.8 million adjusted by depreciation and amortization of $10.4 million, non-cash interest expense of $0.6 million, and a net increase in working capital of $6.0 million, primarily caused by decreases in accounts payable and income taxes payable due to federal and state tax payments made in the first three months of 2011, partially offset by an increase in accrued interest.

Investing activities

Net cash used in investing activities was $1.4 million during the first three months of 2012. Net cash used in investing activities consisted primarily of $1.4 million of property and equipment expenditures.

Net cash used in investing activities was $1.2 million during the first three months of 2011. Net cash used in investing activities consisted of $0.5 million of payments for contract modifications for prepaid residual expenses and $0.7 million of capital expenditures. We currently have no material capital spending or purchase commitments, but expect to continue to engage in capital spending in the ordinary course of business.

Financing activities

Net cash used in financing activities was $18.5 million during the first three months of 2012, consisting of $8.0 million of repayments on the term loan under the Senior Secured Credit Facilities and $10.5 million of net repayments on the revolving facility thereunder.

Net cash used in financing activities was $11.6 million during the first three months of 2011, consisting of $5.8 million of repayments on the term loan under iPayment’s then existing senior secured credit facilities and $5.8 million of net repayments on the then existing revolving facility thereunder.

See Notes 3 and 6 to the consolidated financial statements for further detail regarding the Company’s long-term debt and the Refinancing.

 

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Contractual Obligations

The following table of our material contractual obligations as of March 31, 2012, summarizes the aggregate effect that these obligations are expected to have on our cash flows in the periods indicated.

 

     Payments due by period  

(Dollars in thousands)

   Total      Less than 1 year      1-3 years      4-5 years      More than 5 years  

Contractual Obligations of iPayment

              

Senior Secured Credit Facilities

   $ 357,500       $ —         $ —         $ 357,500       $ —     

10.25% Notes

     400,000         —           —           —           400,000   

Interest, net of discount and amortization(1)

     357,538         62,213         124,425         123,829         47,071   

Operating lease obligations

     14,057         1,719         3,318         3,313         5,707   

Purchase obligations and other(2)

     2,873         734         1,231         908         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total contractual obligations

   $ 1,131,968       $ 64,666       $ 128,974       $ 485,550       $ 452,778   

Contractual Obligations of Holdings

              

15.00%/15.00% Notes(3)

   $ 168,112       $ —         $ —         $ —         $ 168,112   

Interest(1)(3)

     126,449         9,927         22,187         43,901         50,434   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total contractual obligations

   $ 294,561       $ 9,927       $ 22,187       $ 43,901       $ 218,546   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Future interest obligations are calculated using current interest rates on existing debt balances as of March 31, 2012, and assume no principal reduction other than mandatory principal repayments in accordance with the terms of the debt instruments as discussed in Note 6 to the consolidated financial statements.
(2) Purchase obligations represent costs of contractually guaranteed minimum processing volumes with certain of our third-party transaction processors and other service-related obligations.
(3) Assumes that (i) for all interest periods through and including May 15, 2015, Holdings will pay interest on 50% of the outstanding principal amount of its 15.00%/15.00% Notes in cash and 50% in kind and (ii) after May 15, 2015, Holdings will make all interest payments on the 15.00%/15.00% Notes entirely in cash.

We expect to be able to fund our operations, capital expenditures and the contractual obligations above (other than the repayment at maturity of the aggregate principal amount of (i) term loans under the Senior Secured Credit Facilities and (ii) the Notes) using our cash from operations. We intend to use our revolving facility primarily to fund temporary working capital needs and additional acquisition opportunities as they arise. To the extent we are unable to fund our operations, capital expenditures and the contractual obligations above using cash from operations, we intend to use borrowings under our revolving facility or future debt or equity financings. In addition, we may seek to sell additional equity or arrange debt financing to give us financial flexibility to pursue attractive opportunities that may arise in the future. If we raise additional funds through the sale of equity or convertible debt securities, these transactions may dilute the value of our outstanding common stock. We may also decide to issue securities, including debt securities, which have rights, preferences and privileges senior to our common stock. If future financing is not available or is not available on acceptable terms, we may not be able to fund our future needs, which may prevent us from increasing our market share, capitalizing on new business opportunities or remaining competitive in our industry.

New Accounting Standards

In May 2011, the FASB issued ASU No. 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” The provisions of ASU No. 2011-04 result in a consistent definition of fair value and common requirements for the measurement of and disclosure about fair value between U.S. GAAP and International Financial Reporting Standards (“IFRS”). The changes to U.S. GAAP as a result of ASU No. 2011-04 are as follows: (1) The concepts of highest and best use and valuation premise are only relevant when measuring the fair value of nonfinancial assets (that is, it does not apply to financial assets or any liabilities); (2) U.S. GAAP currently prohibits application of a blockage factor in valuing financial instruments with quoted prices in active markets. ASU No. 2011-04 extends that prohibition to all fair value measurements; (3) An exception is provided to the basic fair value measurement principles for an entity that holds a group of financial assets and financial liabilities with offsetting positions in market risks or counterparty credit risk that are managed on the basis of the entity’s net exposure to either of those risks. This exception allows the entity, if certain criteria are met, to measure the fair value of the net asset or liability position in a manner consistent with how market participants would price the net risk position; (4) Aligns the fair value measurement of instruments classified within an entity’s shareholders’ equity with the guidance for liabilities; and (5) Disclosure requirements have been enhanced for Level 3 fair value measurements to disclose quantitative information about unobservable inputs and assumptions used, to describe the valuation processes used by the entity, and to qualitatively describe the sensitivity of fair value measurements to changes in unobservable inputs and the interrelationships between those inputs. In addition, entities must report the level in the fair value hierarchy of items that are not measured at fair value in the statement of condition but whose fair value must be disclosed. The Company adopted the provisions of ASU No. 2011-04 effective January 1, 2012. The fair value measurement provisions of ASU No. 2011-04 had no impact on the Company’s consolidated financial statements.

 

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In June 2011, the FASB issued ASU No. 2011-05, “Presentation of Comprehensive Income.” The provisions of ASU No. 2011-05 allow an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income. Under either method, entities are required to present on the face of the financial statements reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. ASU No. 2011-05 also eliminates the option to present the components of other comprehensive income as part of the statement of changes in shareholders’ equity but does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income. ASU No. 2011-05 was effective for the Company’s interim reporting period beginning on or after January 1, 2012, with retrospective application required. In December 2011, the FASB issued ASU No. 2011-12, “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” The provisions of ASU No. 2011-12 defer indefinitely the requirement for entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. ASU No. 2011-12, which shares the same effective date as ASU No. 2011-05, does not defer the requirement for entities to present components of comprehensive income in either a single continuous statement of comprehensive income or in two separate but consecutive statements. The Company adopted the provisions of ASU No. 2011-05 and ASU No. 2011-12 which resulted in a new statement of comprehensive income for the interim period ended March 31, 2012.

Effects of Inflation

Our monetary assets, consisting primarily of cash and receivables, are not significantly affected by inflation. Our non-monetary assets, consisting primarily of intangible assets and goodwill, are not affected by inflation. We believe that replacement costs of equipment, furniture and leasehold improvements will not materially affect our operations. However, the rate of inflation affects our expenses, such as those for employee compensation and other operating expenses, which may not be readily recoverable in the price of services offered by us. The rate of inflation can also affect our revenues by affecting our merchant charge volume and corresponding changes to processing revenue.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

In addition to the effects of inflation described above under “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Effects of Inflation,” the following is a description of additional market risks to which we may be exposed.

We transact business with merchants exclusively in the United States and receive payment for our services exclusively in United States dollars. As a result, our financial results are unlikely to be materially affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets.

Our interest expense is sensitive to changes in the general level of interest rates in the credit markets because a significant amount of our indebtedness is subject to variable rates. As of March 31, 2012, we had $357.5 million of loans outstanding under our Senior Secured Credit Facilities, all of which were at a variable interest rate based on LIBOR, subject to a floor equal to 1.50%. Accordingly, a one percent increase in the applicable LIBOR above the floor would result in net additional annual interest expense on our outstanding borrowings as of March 31, 2012 of approximately $3.6 million.

We do not hold any derivative financial or commodity instruments, nor do we engage in any foreign currency denominated transactions, and all of our cash and cash equivalents are held in money market and checking funds.

Item 4. Controls and Procedures.

Restatement of Financial Statements

In August 2012, as disclosed in the Company’s Current Reports on Form 8-K filed on September 12, 2012 and November 5, 2012, the Company and Holdings were presented with accusations from one of the Company’s employees that certain of the Company’s employees and outside contractors had engaged in financial misconduct. Following an initial inquiry into these accusations by the Company, the Board of Directors of the Company and management conducted an internal investigation of the alleged misconduct. During the course of the Company’s investigation, certain executives of the Company and Holdings were terminated or resigned. Based on the results of the Company’s internal investigation and the financial impact thereof on prior financial periods, the Board of Directors and management concluded that the Affected Financial Statements should no longer be relied upon. The material weaknesses described below led to the need for the restatement of the Company’s financial statements for the years ended December 31, 2009, 2010 and 2011 (including all interim periods within such years) and for the first two quarters of 2012 and the failure of the Company to file on a timely basis its Quarterly Report on Form 10-Q for the interim period ended September 30, 2012.

 

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Disclosure Controls and Procedures

Our management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, maintains disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)) that are designed to provide reasonable assurance that information required to be disclosed under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized and reported within the time periods specified and 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.

Our management, under the supervision and with the participation of our Board of Directors, Chief Executive Officer and Chief Financial Officer, conducted an evaluation, pursuant to Rule 13a-15(c) and 15d-15(d) promulgated under the Exchange Act, of the effectiveness of its disclosure controls and procedures. The Board of Directors and management concluded that our disclosure controls and procedures were not effective as of December 31, 2009, 2010 and 2011 or as of March 31, 2012, due to the material weaknesses in our internal controls over financial reporting described below.

Internal Control over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) promulgated under the Exchange Act. Internal control over financial reporting is a process designed by, or under the supervision of, the issuer‘s principal executive and principal financial officers, or persons performing similar functions, and effected by the issuer‘s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer;

(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and

(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer‘s assets that could have a material effect on the financial statements.

Our internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation and fair presentation of published financial statements for external purposes in accordance with generally accepted accounting principles (“GAAP”). All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.

Our management, under the supervision and with the participation of our Board of Directors, Chief Executive Officer and Chief Financial Officer, conducted an evaluation, pursuant to Rule 13a-15(c) and 15d-15(d) promulgated under the Exchange Act, of the effectiveness of its internal control over financial reporting. Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2009, 2010 and 2011 and as of March 31, 2012 based on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control Integrated Framework. The Board of Directors and management concluded that our internal control over financial reporting was not effective as of December 31, 2009, 2010 and 2011 or as of March 31, 2012 due to the five material weaknesses described below. A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. The existence of one or more material weaknesses precludes a conclusion by management that a corporation’s internal control over financial reporting is effective.

Material Weaknesses

In connection with the assessment described above, management of the Company concluded that five material weaknesses existed in the Company’s internal control over financial reporting.

Entity Level Controls: Certain of the Company’s entity level controls within its control environment were not effectively designed or applied to prevent former members of senior management and other employees from having the ability to circumvent or override controls around residual payments, expense reimbursements, and vendor administration. The Company did not maintain an adequate control environment that set a proper culture within our operations to instill an attitude of compliance and control awareness;

 

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including training of our accounting, information technology and operations managers to emphasize the importance of setting the proper culture within our organization, a thorough and proper analysis of proposed transactions, and an effective standardized review process. This material weakness in the Company’s entity level controls increased the likelihood of a material misstatement occurring within the Company’s interim and annual financial statements and not being prevented or detected.

Accounts Payable: Misappropriation of Company assets occurred as a result of an inadequate design of controls around vendor due diligence review and bidding, as well as the override of certain existing controls in the areas of master vendor file data administration and approval of vendor invoices. Certain members of senior management colluded with third party vendors to submit fictitious invoices which were paid by the Company. Those vendors then paid “kickbacks” to certain members of senior management. The override of controls by certain members of senior management responsible for the application and adherence to control procedures further resulted in those fraudulent invoices being inappropriately capitalized to software development and subsequently amortized.

Sales Agent Verification: The Company did not maintain effective internal controls with respect to verifying the authenticity of sales agents or preventing the re-direction of residual payments to fictitious sales agent accounts created by certain members of management. The sales agent review and approval process contained design and operating control deficiencies causing material errors in the Company’s financial statements which were not detected on a timely basis by management in the normal course of business. As compensation for the referral of merchant accounts, the Company pays its sales agents an agreed-upon residual, or a percentage of the income derived from the transactions processed from the merchants they refer. However, merchant accounts that are generated by the Company’s direct sales channels or that are acquired pursuant to acquisitions are typically not subject to residual payments and are labeled “house” accounts. The Company also did not design or maintain effective controls related to residual payments, post-residual payment quality control verification, and the movement of merchant accounts, including “house” accounts.

Due to a lack of effective system access controls and procedures with respect to verifying the authenticity of sales agents, as well as the lack of effective control over the movement of “house” accounts, fraudulent offices were established within the Company’s residual payment system, certain “house” merchant accounts were transferred to fraudulent sales agents created by certain former members of management and residual payments were subsequently improperly made to those fraudulent sales agent accounts.

Expense Reimbursements: Misappropriation of Company assets occurred due to the lack of appropriate review and approval controls around expense reimbursements. Certain employees were allowed to use personal credit cards to make large dollar purchases rather than those purchases being centrally approved by the purchasing department and centrally processed by the accounts payable department. Further, certain members of senior management created fictitious vendor invoices which were approved by other members of senior management and then paid by the Company. The override of existing controls as well as poorly designed controls over the expense reimbursement process, including lack of policies and controls to preclude fixed assets from being reimbursed through expense reports, resulted in certain fraudulent reimbursements, some of which were inappropriately capitalized to fixed assets and subsequently depreciated.

Manual Journal Entries: A material weakness was identified due to the lack of effective policies and procedures over manual journal entries. Specifically, effective policies and procedures were not in place to ensure that manual journal entries were accompanied by sufficient supporting documentation, that supporting documentation was properly retained, and that these journal entries were adequately reviewed and approved. The existence of design and operating control deficiencies around manual journal entries is considered to be a material weakness, as the lack of policies and proper review and approval of manual journal entries could have resulted in a material misstatement of the Company’s annual and interim financial statements for the periods in which the misconduct took place.

Remediation Steps to Address Material Weaknesses

The Company’s management has been engaged, and continues to engage, in making necessary changes and improvements to the overall design of its control environment to address the material weaknesses in internal control over financial reporting and the ineffectiveness of the Company’s disclosure controls and procedures described above.

Entity Level Controls: To remediate the material weakness described above under “Entity Level Controls,” the Company continues to enhance its training of management, including its accounting, information technology, and operations managers, to emphasize further the importance of setting the proper tone within the organization to instill an attitude of integrity and control awareness and the use of a thorough and proper analysis of proposed transactions. The former employees who initiated or directed the fraud discussed in Note 2 to our consolidated financial statements “Restatement of Consolidated Financial Statements,” were either terminated by the Company or have resigned, and the Company has hired additional qualified accounting and operations personnel. Lastly, the Company has implemented the specific remediation initiatives described below in the fiscal year 2012. These initiatives are intended to provide reasonable assurance regarding the reliability and completeness of the Company’s financial information and disclosures.

Accounts Payable: To remediate the material weakness described above under “Accounts Payable,” the Company has implemented a thorough vendor master due diligence review along with a competitive vendor bidding process. The Company has implemented controls surrounding manual journal entry reviews to capture errors or irregularities within financial reporting including capitalized software development. The Company has also enhanced its entity-level control environment to include related party disclosures for all managers and above.

 

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Sales Agent Verification: To remediate the material weakness described above under “Sales Agent Verification,” the Company has implemented revised policies and procedures around the creation and authorization of new sales agents, monthly review of residual payments, post- residual payment quality control verification, and the movement of merchant accounts, including “house” accounts. The Company will continue to assess its standardized processes to further enhance the effectiveness of financial reviews, including the analysis and monitoring of financial information in a consistent and thorough manner.

Expense Reimbursements: To remediate the material weakness described above under “Expense Reimbursements” , the Company has implemented certain interim revised policies and procedures for travel and entertainment expenditures and the associated approvals of those expenditures. Under the revised policies and procedures, fixed assets can no longer be purchased through expense reports. The Company is also working to strengthen controls in this area, including instituting a corporate credit card program with strict spending limits as well as enforcement of a centralized purchasing system.

Manual Journal Entries: To remediate the material weakness described above under “Manual Journal Entries” the Company has implemented certain revised policies and procedures associated with the preparation and retention of supporting documentation as well as the review and approval of manual journal entries. Under the revised policies and procedures, evidence of proper review and approval of supporting documentation will be required prior to the posting of manual journal entries. In addition, the revised policies and procedures are designed to ensure that journal entries will be tracked and supporting documentation is appropriately retained.

Management believes there is a need to continue to enhance the effectiveness of the standardized review processes and the remediation measures described above. The policies, procedures, and controls identified have not been operated for an adequate period of time to conclude that the material weaknesses identified above have been remediated. However, the actions described above have significantly improved our internal control over financial reporting by creating and maintaining a control environment in our operations management that are intended to set a proper ethical tone within our operations organization to instill an attitude of compliance and control awareness.

Changes in Internal Control over Financial Reporting

Except for the material weaknesses identified in respect of our entity level controls, sales agent verification and residual process, accounts payable process, expense reimbursement process, and manual journal entry process as discussed above, there have not been any changes in our internal control over financial reporting for the quarter ended March 31, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

We are party to certain legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the ultimate outcome of these matters cannot be predicted with certainty, based on information currently available, advice of counsel, and available insurance coverage, we do not believe that the outcome of any of these claims will have a material adverse effect on our business, financial condition or results of operations. However, the results of legal proceedings cannot be predicted with certainty, and in the event of unexpected future developments the ultimate resolution of one or more of these matters could be unfavorable. Should we fail to prevail in any of these legal matters or should several of these legal matters be resolved against us in the same reporting period, our consolidated financial position or operating results could be materially adversely affected. Regardless of the outcome, any litigation may require us to incur significant litigation expenses and may result in significant diversion of management’s attention. All litigation settlements are recorded within “other expense” on our consolidated statements of operations.

As of the filing date of this Quarterly Report, there have been no material developments in the legal proceedings described in Item  3 of our Amended 2011 Annual Report.

Item 1A. Risk Factors.

Certain risks associated with our business, our indebtedness, and acquisitions we have made or may make are discussed in our Amended 2011 Annual Report under the heading “Risk Factors” in Item 1A of that report. We do not believe there have been any material changes in these risks.

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Mine Safety Disclosures.

Not applicable.

Item 5. Other Information.

None

Item 6. Exhibits.

See the Exhibit Index following the signature page to this Quarterly Report for a list of exhibits filed or furnished with this report, which Exhibit Index is incorporated herein by reference.

 

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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.

 

    iPayment Holdings, Inc.

Date: January 31, 2013

    By:  

/s/ Carl A. Grimstad

    Carl A. Grimstad
    Chief Executive Officer, President and Director
    (Principal Executive Officer)

Date: January 31, 2013

    By:  

/s/ Mark C. Monaco

    Mark C. Monaco
   

Executive Vice President, Chief Financial Officer,

Treasurer and Director

(Principal Financial and Accounting Officer)

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.

 

    iPayment, Inc.
Date: January 31, 2013     By:  

/s/ Carl A. Grimstad

   

Carl A. Grimstad

Chairman, Chief Executive Officer and President

(Principal Executive Officer)

Date: January 31, 2013     By:  

/s/ Mark C. Monaco

   

Mark C. Monaco

Executive Vice President, Chief Financial Officer,

Treasurer and Director

(Principal Financial and Accounting Officer)

 

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EXHIBIT INDEX

 

Exhibit

       

Incorporated herein by reference

Number

 

Description

  

Form

  

Date

3.1   Restated Certificate of Incorporation of iPayment Holdings, Inc.   

Registration Statement on

Form S-4

   October 11, 2011
3.2   Bylaws of iPayment Holdings, Inc.   

Registration Statement on

Form S-4

   October 11, 2011
3.3   Certificate of Incorporation of iPayment, Inc., attached as Exhibit A to the Certificate of Merger of iPayment Merger Co., Inc. into iPayment, Inc.   

Registration Statement on

Form S-4

   July 21, 2006
3.4   Bylaws of Merger Co., as adopted by iPayment, Inc.   

Registration Statement on

Form S-4

   July 21, 2006
31.1*   Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a – 14(a) (as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002).      
31.2*   Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a – 14(a) (as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002).      
32.1**   Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a – 14(b) and 18 U.S.C. 1350 (as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002).      
32.2**   Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a – 14(b) and 18 U.S.C. 1350 (as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002).      
101.INS†   XBRL Instance Document      
101.SCH†   XBRL Taxonomy Extension Schema Document      
101.CAL†   XBRL Taxonomy Extension Calculation Linkbase Document      
101.DEF†   XBRL Taxonomy Extension Definition Linkbase Document      
101.LAB†   XBRL Taxonomy Extension Label Linkbase Document      
101.PRE†   XBRL Taxonomy Extension Presentation Linkbase Document      

 

* Filed herewith.
** Furnished herewith.
XBRL (Extensible Business Reporting Language) information is furnished and not filed or a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act, is deemed not filed for purposes of section 18 of the Exchange Act, and otherwise is not subject to liability under these sections.

 

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