| MEDALLION FINANCIAL CORP ITEM 1A RISK FACTORS Interest rate fluctuations may adversely affect the interest rate spread we receive on our taxicab medallion and commercial loans |
| Because we borrow money to finance the origination of loans, our income is dependent upon the difference between the rate at which we borrow funds and the rate at which we loan funds |
| While the loans in our portfolio in most cases bear interest at fixed-rates or adjustable-rates (which adjust at various intervals), we finance a substantial portion of such loans by incurring indebtedness with adjustable or floating interest rates (which adjust immediately to changes in rates) |
| In periods of sharply rising interest rates, our costs of funds would increase, which would reduce our portfolio income before net realized and unrealized gains |
| Accordingly, like most financial services companies, we face the risk of interest rate fluctuations |
| Although we intend to continue to manage our interest rate risk through asset and liability management, including the use of interest rate caps, to achieve a positive asset/liability gap at year end, general rises in interest rates may reduce our interest rate spread in the short term |
| In addition, we rely on our counterparties to perform their obligations under such interest rate caps |
| A decrease in prevailing interest rates may lead to more loan prepayments, which could adversely affect our business |
| Our borrowers generally have the right to prepay their loans upon payment of a fee ranging from 30 to 120 days interest |
| A borrower is likely to exercise prepayment rights at a time when the interest rate payable on the borrower’s loan is high relative to prevailing interest rates |
| In a lower interest rate environment, we will have difficulty re-lending prepaid funds at comparable rates, which may reduce the net interest margin we receive |
| We have traditionally qualified to be a RIC, and in order to be taxed as a RIC we must distribute our income |
| Therefore, we may have a continuing need for capital if we continue to be taxed as a RIC in the future |
| We have a continuing need for capital to finance our lending activities |
| Our current sources of capital and liquidity are the following: • line of credit for medallion lending; • raising deposits at MB; 16 ______________________________________________________________________ [42]Table of Contents • loan amortization and prepayments; • sales of participation interests in loans; and • borrowings from other financial intermediaries |
| In order to be taxed as a RIC, we are required to distribute at least 90prca of our investment company taxable income; consequently, we have primarily relied upon external sources of funds to finance growth |
| At December 31, 2005, we had dlra15cmam000cmam000 under a Fed Funds Line with a commercial bank, dlra12cmam343cmam000 available under revolving credit agreements with commercial banks, and dlra1cmam950cmam000 of additional deposits that can be raised by MB at existing capital levels |
| Additionally, In March 2006, the SBA approved a dlra13cmam500cmam000 commitment for MCI to issue additional debentures to the SBA during a ten year period upon payment of a 1prca fee and the infusion of dlra4cmam500cmam000 of additional capital |
| We may have difficulty raising capital to finance our planned level of lending operations |
| Although the Company has demonstrated an ability to meet significant debt amortization requirements in the past, received approval to operate MB and begin raising federally-insured deposits, and has several existing sources of liquidity, there can be no assurance that additional funding sources to meet amortization requirements or future growth targets will be successfully obtained |
| See the additional discussion related to the credit facilities and note agreements in the Liquidity and Capital Resources section on page 40 |
| Due to the Company’s late filing of the 2004 Form 10-K, the Company could have restrictions imposed on it by rules of NASDAQ and the SEC Such restrictions could include, and are not limited to, such items as not being able to file short form registration statements if the Company were to issue additional common stock to the public |
| The Company has no current plans for additional equity offerings |
| Lending to small businesses involves a high degree of risk and is highly speculative |
| Lending to small businesses involves a high degree of business and financial risk, which can result in substantial losses and should be considered speculative |
| Our borrower base consists primarily of small business owners that have limited resources and that are generally unable to achieve financing from traditional sources |
| There is generally no publicly available information about these small business owners, and we must rely on the diligence of our employees and agents to obtain information in connection with our credit decisions |
| In addition, these small businesses often do not have audited financial statements |
| Some smaller businesses have narrower product lines and market shares than their competition |
| Therefore, they may be more vulnerable to customer preferences, market conditions or economic downturns, which may adversely affect the return on, or the recovery of, our investment in these businesses |
| Our borrowers may default on their loans |
| We primarily invest in and lend to companies that may have limited financial resources |
| Numerous factors may affect a borrower’s ability to repay its loan, including: • the failure to meet its business plan; • a downturn in its industry or negative economic conditions; • the death, disability or resignation of one or more of the key members of management; or • the inability to obtain additional financing from traditional sources |
| Deterioration of a borrower’s financial condition and prospects may be accompanied by deterioration of the collateral for the loan |
| Expansion of our portfolio and increases in the proportion of our portfolio consisting of commercial loans could have an adverse impact on the credit quality of the portfolio |
| We borrow money, which may increase the risk of investing in our common stock |
| We use financial leverage through banks and our long-term subordinated SBA debentures |
| Leverage poses certain risks for our stockholders, including the following: • it may result in higher volatility of both our net asset value and the market price of our common stock; • since interest is paid to our creditors before any income is distributed to our stockholders, fluctuations in the interest payable to our creditors may decrease the dividends and distributions to our stockholders; and • in the event of a liquidation of the Company, our creditors would have claims on our assets superior to the claims of our stockholders |
| 17 ______________________________________________________________________ [43]Table of Contents If we are unable to continue to diversify geographically, our business may be adversely affected if the New York City taxicab industry experiences a sustained economic downturn |
| Although we have diversified from the New York City area, a significant portion of our loan revenue is derived from New York City medallion loans collateralized by New York City taxicab medallions |
| An economic downturn in the New York City taxicab industry could lead to an increase in defaults on our medallion loans |
| There can be no assurance that we will be able to sufficiently diversify our operations geographically |
| An economic downturn could result in certain of our commercial and consumer loan customers experiencing declines in business activities, which could lead to difficulties in their servicing of their loans with us, and increasing the level of delinquencies, defaults, and loan losses in our commercial and consumer loan portfolios |
| Although the Company believes the estimates and assumptions used in determining the recorded amounts of net assets and liabilities at December 31, 2005 are reasonable, actual results could differ materially from the estimated amounts recorded in the Company’s financial statements |
| The loss of certain key members of our senior management could adversely affect us |
| Our success is largely dependent upon the efforts of senior management |
| The death, incapacity, or loss of the services of certain of these individuals could have an adverse effect on our operations and financial results |
| There can be no assurance that other qualified officers could be hired |
| Acquisitions may lead to difficulties that could adversely affect our operations |
| By their nature, corporate acquisitions entail certain risks, including those relating to undisclosed liabilities, the entry into new markets, operational, and personnel matters |
| We may have difficulty integrating acquired operations or managing problems due to sudden increases in the size of our loan portfolio |
| In such instances, we might be required to modify our operating systems and procedures, hire additional staff, obtain and integrate new equipment, and complete other tasks appropriate for the assimilation of new business activities |
| There can be no assurance that we would be successful, if and when necessary, in minimizing these inherent risks or in establishing systems and procedures which will enable us to effectively achieve our desired results in respect of any future acquisitions |
| Competition from entities with greater resources and less regulatory restrictions may decrease our profitability |
| We compete with banks, credit unions, and other finance companies, some of which are SBICs, in the origination of taxicab medallion, commercial, and consumer loans |
| Many of these competitors have greater resources than the Company, and certain competitors are subject to less restrictive regulations than the Company |
| As a result, there can be no assurance that we will be able to continue to identify and complete financing transactions that will permit us to continue to compete successfully |
| The valuation of our loan portfolio is subjective and we may not be able to recover our estimated value in the event of a foreclosure or sale of a substantial portion of portfolio loans |
| Under the 1940 Act, our loan portfolio must be recorded at fair value or “marked-to-market |
| ” Unlike other lending institutions, we are not permitted to establish reserves for loan losses |
| Instead, the valuation of our investment portfolio is adjusted quarterly to reflect our estimate of the current realizable value of our loan portfolio |
| Since no ready market exists for this portfolio, fair value is subject to the good faith determination of our management and the approval of our Board of Directors |
| Because of the subjectivity of these estimates, there can be no assurance that in the event of a foreclosure or the sale of portfolio loans we would be able to recover the amounts reflected on our balance sheet |
| If liquidity constraints required the sale of a substantial portion of the portfolio, such an action may require the sale of certain assets at amounts less than their carrying amounts |
| 18 ______________________________________________________________________ [44]Table of Contents In determining the value of our portfolio, management and the Board of Directors may take into consideration various factors such as the financial condition of the borrower and the adequacy of the collateral |
| For example, in a period of sustained increases in market interest rates, management and the Board of Directors could decrease its valuation of the portfolio if the portfolio consists primarily of fixed-rate loans |
| Our valuation procedures are designed to generate values that approximate the value that would have been established by market forces and are therefore subject to uncertainties and variations from reported results |
| Considering these factors, we have determined that the fair value of our portfolio is below its cost basis |
| At December 31, 2005, our net unrealized depreciation on investments was approximately dlra12cmam535cmam793 or 1dtta70prca of our investment portfolio |
| Based upon current market conditions and current loan-to-value ratios, management believes, and our Board of Directors concurs, that the net unrealized depreciation on investments is adequate to reflect the fair value of the portfolio |
| Changes in taxicab industry regulations that result in the issuance of additional medallions could lead to a decrease in the value of our medallion loan collateral |
| Every city in which we originate medallion loans, and most other major cities in the US, limits the supply of taxicab medallions |
| This regulation results in supply restrictions that support the value of medallions |
| Actions that loosen these restrictions and result in the issuance of additional medallions into a market could decrease the value of medallions in that market |
| If this were to occur, the value of the collateral securing our then outstanding medallion loans in that market could be adversely affected |
| New York City determined to increase the number of medallions by 900, auctioned over a three year period beginning in 2004, preceded by a 25prca fare hike |
| The first of these auctions for 300 medallions concluded in April 2004, and the second for 300 medallions concluded in October 2004, and both generated high levels of bid activity and record medallion prices |
| Although there can be no assurances, we would expect the final auction in 2006 to obtain similar results |
| We are unable to forecast with any degree of certainty whether any other potential increases in the supply of medallions will occur |
| In New York City, Chicago, Boston, and in other markets where we originate medallion loans, taxicab fares are generally set by government agencies |
| Expenses associated with operating taxicabs are largely unregulated |
| Escalating expenses can render taxicab operations less profitable, and could cause borrowers to default on loans from the Company, and could potentially adversely affect the value of the Company’s collateral |
| As mentioned above, New York City approved a 25prca fare increase as a part of the auction program which was effective May 1, 2004 |
| A significant portion of our loan revenue is derived from loans collateralized by New York City taxicab medallions |
| According to New York City Taxi and Limousine Commission data, over the past 20 years New York City taxicab medallions have appreciated in value an average of 10prca each year |
| However, for sustained periods during that time, taxicab medallions have declined in value |
| During 2005, the value of New York City taxicab medallions increased by approximately 5prca for individual medallions and 4prca for corporate medallions |
| Our failure to re-establish our RIC status in 2004 and beyond could lead to a substantial reduction in the amount of income distributed to our shareholders |
| In 2003, changes were enacted to the federal tax laws which, among other things, significantly reduced the tax rate on dividends paid to shareholders from a corporation’s previously taxed income |
| Assuming we qualify as a RIC for 2005 or subsequent taxable years, we are unable to predict the effect of such changes upon our common stock |
| If we do not file as a RIC for more than two consecutive years, and then seek to requalify and elect RIC status, we would be required to recognize gain to the extent of any unrealized appreciation on our assets unless we make a special election to pay corporate-level tax on any such unrealized appreciation recognized during the succeeding 10-year period |
| Absent such special election, any gain we recognize would be deemed distributed to our stockholders as a taxable distribution |
| To qualify and be taxed as a RIC, we must meet certain income, diversification, and distribution requirements |
| However, because we use leverage, we are subject to certain asset coverage ratio requirements set forth in the 1940 Act |
| These asset coverage requirements could, under certain circumstances, prohibit us from making distributions that are necessary to maintain our RIC status or require that we reduce our leverage |
| 19 ______________________________________________________________________ [45]Table of Contents In addition, the asset coverage and distribution requirements impose significant cash flow management restrictions on us and limit our ability to retain earnings to cover periods of loss, provide for future growth and pay for extraordinary items |
| Qualification as a RIC is made on an annual basis and, although we and some of our subsidiaries qualified as regulated investment companies in the past, no assurance can be given that each will qualify for such treatment in 2005 and beyond |
| Failure to qualify as a RIC would subject us to tax on our income and could have material adverse effects on our financial condition and results of operations |
| Our SBIC subsidiaries may be unable to meet the investment company requirements, which could result in the imposition of an entity-level tax |
| The SBIA regulates some of our subsidiaries |
| The SBIA restricts distributions by a SBIC Our SBIC subsidiaries that are also RICs could be prohibited by SBA regulations from making the distributions necessary to qualify as a RIC Each year, in order to comply with the SBA regulations and the RIC distribution requirements, we must request and receive a waiver of the SBA’s restrictions |
| While the current policy of the SBA’s Office of SBIC Operations is to grant such waivers if the SBIC makes certain offsetting adjustments to its paid-in capital and surplus accounts, there can be no assurance that this will continue to be the SBA’s policy or that our subsidiaries will have adequate capital to make the required adjustments |
| If our subsidiaries are unable to obtain a waiver, compliance with the SBA regulations may result in loss of RIC status and a consequent imposition of an entity-level tax |
| The Internal Revenue Code’s diversification requirements may limit our ability to expand our business |
| These requirements provide that to qualify as a RIC, not more than 25prca of the value of our total assets may be invested in the securities (other than US Government securities or securities of other RICs) of any one issuer |
| While our investments in RIC subsidiaries are not subject to this diversification test so long as these subsidiaries qualify as RICs, our investments in CCU and MB would be subject to this test, and could impact requalification as a RIC The merger of Media into CCU in exchange for stock created a diversification issue as well, as it represents 12prca of the Company’s RIC assets |
| The level of the investment will need to be monitored to ensure it remains within the diversification guidelines |
| Additionally the Company’s investment in MB, while representing 22prca of the Company’s total RIC assets at December 31, 2005, currently falls within the guidelines of the 25prca test described above |
| However, as an anticipated future growth vehicle of the Company, the investment in MB will need to be monitored for continued compliance with the test |
| Our past use of Arthur Andersen LLP as our independent auditors may pose risks to us and also limit your ability to seek potential recoveries from them related to their work |
| Effective July 29, 2002, the Company dismissed its independent auditors, Arthur Andersen LLP (Andersen), in view of recent developments involving Andersen, at that time |
| As a public company, we are required to file periodic financial statements with the SEC that have been audited or reviewed by an independent accountant |
| As our former independent auditors, Andersen provided a report on our consolidated financial statements as of and for each of the five fiscal years in the period ended December 31, 2001 |
| SEC rules require us to obtain Andersen’s consent to the inclusion of its audit report in our public filings |
| However, Andersen was indicted and found guilty of federal obstruction of justice charges, and has informed the Company that it is no longer able to provide such consent as a result of the departure from Andersen of the former partner and manager responsible for the audit report |
| Under these circumstances, Rule 437A under the Securities Act of 1933, as amended, permits the Company to incorporate the audit report and the audited financial statements without obtaining the consent of Andersen |
| The SEC has recently provided regulatory relief designed to allow public companies to dispense with the requirement that they file a consent of Andersen in certain circumstances |
| Notwithstanding this relief, the inability of Andersen to provide either its consent or customary assurance services to us now and in the future could negatively affect our ability to, among other things, access the public capital markets |
| Any delay or inability to access the public markets as a result of this situation could have a material adverse impact on our business, financial condition, and results of operations |
| 20 ______________________________________________________________________ [46]Table of Contents We depend on cash flow from our subsidiaries to make dividend payments and other distributions to our shareholders |
| We are primarily a holding company, and we derive most of our operating income and cash flow from our subsidiaries |
| As a result, we rely heavily upon distributions from our subsidiaries to generate the funds necessary to make dividend payments and other distributions to our shareholders |
| Funds are provided to us by our subsidiaries through dividends and payments on intercompany indebtedness, but there can be no assurance that our subsidiaries will be in a position to continue to make these dividend or debt payments |
| Furthermore, as a condition of its approval by its regulators, MB is precluded from making any dividend payments for its first three years of operations |
| We operate in a highly regulated environment |
| We are regulated by the SEC, the SBA, the FDIC, and the Utah Department of Financial Institutions |
| In addition, changes in the laws or regulations that govern BDCs, RICs, SBICs, or banks may significantly affect our business |
| Laws and regulations may be changed from time to time, and the interpretations of the relevant laws and regulations also are subject to change |
| Any change in the laws or regulations that govern our business could have a material impact on our operations |
| Our use of brokered deposit sources for MB’s deposit-gathering activities may not be available when needed |
| MB relies on the established brokered deposit market to originate deposits to fund its operations |
| While MB has developed contractual relationships with a diversified group of investment brokers, and the brokered deposit market is well-developed and utilized by many banking institutions, conditions could change that might affect the availability of deposits |
| If the capital levels at MB fall below the “well-capitalized” level, or if MB experiences a period of sustained operating losses, the cost of attracting deposits from the brokered deposit market could increase significantly, and the ability of MB to raise deposits from this source could be impaired |
| MB’s ability to manage its growth to stay within the “well-capitalized” level, and the capital level currently required by the FDIC during MB’s first three years of operation, which is also considerably higher than the level required to be classified as “well-capitalized”, is critical to MB’s retaining open access to this funding source |
| Consumer lending is a new product line for us that carries a higher risk of loss and could be adversely affected by an economic downturn |
| The acquisition of the consumer loan portfolio, and the subsequent commencement of lending operations in this line of business, represents an entry into a new lending market for the Company |
| Although the purchased portfolio was seasoned, and MB management has considerable experience in originating and managing consumer loans, there can be no assurances that these loans will perform at their historical levels as expected under MB’s management |
| By its nature, lending to consumers that have blemishes on their credit reports carries with it a higher risk of loss |
| Although the net interest margins should be higher to compensate the Company for this increased risk, an economic downturn could result in higher loss rates and lower returns than expected, and could affect the profitability of the consumer loan portfolio |