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FIRST MARBLEHEAD CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following discussion and analysis of our financial condition and results of operations together with our "Selected Financial Data" included in Item 6 of this annual report and "Financial Statements and Supplementary Data" included in Item 8 of this annual report. In addition to historical information, this discussion of our financial condition and results of operations contains certain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those expressed or implied by the forward-looking statements due to applications of our critical accounting policies and factors including, but not limited to, those set forth under the caption "Risk Factors" included in Item 1A of this annual report. Executive Summary Overview We are a specialty finance company focused on the education financing marketplace in the United States. We provide loan programs on behalf of our lender clients for undergraduate and graduate students and for college graduates seeking to refinance private education loan obligations. We offer a fully integrated suite of services through our Monogram platform. We partner with lenders to design and administer education loan programs through our Monogram platform, which are typically school-certified. These programs are designed to be marketed through educational institutions or to prospective borrowers and their families directly and to generate portfolios intended to be held by the originating lender or financed in the capital markets. In addition, we offer outsourced tuition planning, tuition billing, refund management and payment technology services through TMS as well as loan processing and disbursement services through Cology LLC. We also offer a number of other services on a stand-alone, fee-for-service basis in support of our clients, including loan origination, portfolio management and securitization services. Through Union Federal, we offer traditional retail banking products, including residential and commercial mortgages, time deposits and money market demand accounts, on a stand-alone basis. In addition, Union Federal previously generated additional revenues by originating Monogram-based education loan portfolios. On May 28, 52 -------------------------------------------------------------------------------- Table of Contents 2014, the Union Federal Board of Directors approved the dissolution of Union Federal and authorized Union Federal to prepare a plan of voluntary dissolution, which plan is subject to the approval of the Union Federal Board of Directors, the OCC and FMD, as the sole stockholder of Union Federal. Also on May 28, 2014, the FMD Board of Directors approved Union Federal's plan to pursue the dissolution of Union Federal and to prepare the plan of voluntary dissolution, which plan is subject to the approval of FMD, as the sole stockholder of Union Federal. Following the dissolution of Union Federal, FMD will cease to offer banking services through Union Federal. On June 13, 2014, Union Federal notified FMD that it would no longer originate education loans under its Monogram-based loan program. As a result of the planned dissolution and our evaluation under ASC 205-20, Presentation of Financial Statements - Discontinued Operations, or ASC 205-20, we presented Union Federal as a discontinued operation in our consolidated financial statements. See Note 3, "Discontinued Operations-Union Federal," in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information. For a detailed description of our product and service offerings, see "Business-Overview" included in Item 1 of this annual report. Loan Processing and Origination Our Monogram platform provides us with an opportunity to originate, administer, manage and finance education loans, and our lender clients' Monogram-based loan programs are a significant component of our return to the education financing marketplace. As of September 10, 2014, we have loan program agreements with three lender clients for Monogram-based loan programs. The education loans that we originate on behalf of our partner lender clients are not included on our consolidated balance sheets but, rather, are included on the balance sheets of our partner lender clients. As such, none of the references in this annual report to education loans included on our consolidated balance sheets include the education loans processed by us on behalf of our partner lender clients. During the second quarter of fiscal 2013, we began to process and disburse education loans through Cology LLC on behalf of its credit union and other lender clients. Cology LLC earns fees primarily based on the number of loan applications, loan certifications and disbursements it processes on behalf of its clients. Because Cology LLC is a loan processer, the education loans that it processes on behalf of its clients are not included on our consolidated balance sheets but, rather, are included on the balance sheets of its clients. As such, none of the references in this annual report to education loans included on our consolidated balance sheets include the education loans processed by Cology LLC on behalf of its clients. The following table presents our loan facilitation metrics with respect to our Monogram-based programs, excluding Union Federal, for fiscal 2014 and fiscal 2013, as well as our loan facilitation metrics with respect to the education loans processed by Cology LLC for these years, which with respect to fiscal 2013, included only the period from its October 19, 2012 acquisition through June 30, 2013. We use the term "facilitated loan" to mean an education loan that has been approved following receipt of all applicant data, including the signed credit agreement, required certifications from the school and applicant and any required income or employment verification. We use the term "disbursed loan" to mean a loan for which loan funds have been disbursed on behalf of the lender. Historically, we have processed the greatest loan application volume during the summer and early fall months, as students and their families seek to borrow money in order to pay tuition costs for the fall semester or the entire academic year. Fiscal 2014 Fiscal 2013 Cology LLC Partnered Partnered (since Lending Cology LLC Total Lending acquisition) Total (dollars in thousands) Facilitated Loans $ 89,268 $ 579,755 $ 669,023 $ 101,343 $ 164,462 $ 265,805 Disbursed Loans 90,659 548,750 639,409 98,260 310,949 409,209 The decline in Monogram-based loan volume from fiscal 2013 to fiscal 2014 was primarily the result of a reduction in marketing spend year-over-year. While the reduction in marketing expenses adversely impacted the level of loan volumes, the reduction improved our overall cost of loan acquisition from fiscal 2013 to fiscal 2014. 53 -------------------------------------------------------------------------------- Table of Contents Portfolio Performance Credit performance of consumer-related loans generally has been adversely affected by general economic conditions in the United States over the past six years. These conditions have included higher unemployment rates and deteriorating credit performance, including higher levels of education loan defaults and lower recoveries on such defaulted loans. Although these conditions have lessened to a certain extent in more recent years, they may have a material adverse effect on consumer loan portfolio performance in the future. Our Monogram-based education loan portfolios are not yet fully exposed to significant adverse portfolio performance because a majority of these portfolios have yet to experience any significant seasoning. Consequently, in evaluating loan portfolio performance, we review projected gross default rates and projected post-default recovery rates. Further, we evaluate the loan portfolio performance of the securitization trusts that we previously facilitated for loans that have similar credit characteristics as the Monogram-based education loan portfolios. Capital Markets We believe that conditions in the capital markets generally improved in fiscal 2014 as compared to recent years. In particular, investors in ABS demonstrated increased interest in ABS backed by private education loans, resulting in a reduction in credit spreads applicable to these securities. In addition, in calendar 2013, private and federal education loan ABS issuances combined exceeded $20.0 billion for the second calendar year in a row. We believe that these trends indicate that the economics of private education loan ABS are starting to become more attractive to issuers in the private education loan securitization marketplace. However, we have not completed a securitization transaction since fiscal 2008, and if we execute a financing transaction in the capital markets, the structure and economics of any such transaction may be materially different from prior transactions that we have sponsored. Such differences may include lower revenues as a result of comparatively wider credit spreads and lower advance rates. Uncertainties Our near-term financial performance and future growth depends, in large part, on our ability to successfully and efficiently market our Monogram platform, TMS offerings and Cology LLC offerings so that we may grow and diversify our client base and revenues. Facilitated and disbursed loan volumes are key elements of our financial results and business strategy, and we believe that the results to date demonstrate market demand for Monogram-based education loans. We have invested in our distribution capabilities over the course of the past three years, including our school sales force and TMS, but we face challenges in increasing loan volumes. For example, competitors with larger customer bases, greater name or brand recognition, or more established customer relationships than those of our clients, have an advantage in attracting loan applicants at a lower acquisition cost than us and making education loans on a recurring, or "serialized," basis. In addition, our future financial results and liquidity position could be materially impacted by the proceedings related to our federal and state income tax returns, including any challenge to the tax refunds previously received as a result of the audit being conducted by the IRS, as well as the possible inclusion of additional taxable income for such tax years under audit. See "-Results of Operations-Fiscal Years ended June 30, 2014, June 30, 2013 and June 30, 2012-Overall Results-Internal Revenue Service Audit," below, Item 3, "Legal Proceedings," and Note 13, "Commitments and Contingencies-Income Tax Matters," in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information. Outlook Our long-term success depends on our ability to attract additional lender clients and otherwise obtain additional sources of interim or permanent financing, such as securitizations or alternative financing transactions. As of September 10, 2014, we have loan program agreements based on our Monogram platform with three lender clients. While we have demonstrated market demand for Monogram-based education loans, we are uncertain as to the degree of market acceptance that our Monogram platform will achieve, particularly in the current 54 -------------------------------------------------------------------------------- Table of Contents economic and regulatory environment where lenders continue to evaluate their education lending business models. Additionally, as one of our current partner lender clients provides the majority of our Monogram-based loan program fees, we are subject to concentration risk as it relates to this revenue stream until we are able to attract additional lender clients. We believe, however, that the credit quality characteristics and interest rates of the Monogram-based loan portfolios originated to date will be attractive to additional potential lender clients, as well as capital markets participants. We also believe that the ability to permanently finance private education loan portfolios through the capital markets would make our products and services more attractive to lenders and would accelerate improvement in our long-term financial results. We are uncertain of the volume of education loans to be generated by the Monogram-based loan programs of our current lender clients, or any additional lender clients, including clients of Cology LLC. It is our view that returning to profitability will be dependent on a number of factors, including our loan capacity and related volumes, expense management and growth at TMS and Cology LLC and our ability to obtain financing alternatives, including our ability to successfully re-enter the securitization market. In particular, we need to generate loan volumes substantially greater than those that we have generated to date, as well as to develop funding capacity for Monogram-based loan programs at loan volume levels greater than those of our current lender clients with lower credit enhancement levels and higher capital markets advance rates than those available today. We must also continue to achieve efficiencies in attracting applicants, through loan serialization or otherwise, in order to reduce our overall cost of loan acquisition. Changes in any of the following factors could materially affect our financial results: • Demand for education financing, which may be affected by changes in limitations established by the federal government on the amount of federal loans that a student can receive, the terms and eligibility criteria for loans and grants under federal or state government programs and legislation currently under consideration; • The extent to which our services and products, including our Monogram platform, TMS offerings and Cology LLC offerings, gain market share and remain competitive at pricing favorable to us; • The amount of education loan volume disbursed under our lender clients' Monogram-based loan programs; • An adverse outcome in any challenge to federal tax refunds previously received in the amounts of $176.6 million and $45.1 million as a result of the audit of our past tax returns currently being conducted by the IRS, including as a result of the NOPAs we received from the IRS on September 10, 2013 that propose to disallow the loss that generated the tax refunds that we previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS' positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal tax adjustments that we estimate to be approximately $300.0 million, excluding interest until such matter is resolved and the assessment of penalties, if any; • An adverse outcome in the purported class action filed against FMD and certain of FMD's current and former officers in the United States District Court for the District of Massachusetts in August 2013 and the related derivative action filed against certain of FMD's current and former officers and certain current and former members of the FMD Board of Directors in the United States District Court for the District of Massachusetts in October 2013, if any insurance that we have does not cover this liability or proves to be insufficient; • Regulatory requirements applicable to TMS and FMD; • Conditions in the education loan financing market, including the costs or availability of financing, rating agency assumptions or actions, and market receptivity to private education loan asset-backed securitizations; 55 -------------------------------------------------------------------------------- Table of Contents • The underlying loan performance of the Monogram-based loan programs, including the net default rates, and the timing and amounts of receipt of excess credit enhancements, if any, that may be material to us; • The resolution of our appeal of the ATB Order in the cases pertaining to our Massachusetts state income tax returns; • Application of critical accounting policies and estimates, which impact the carrying value of assets and liabilities; • Application of the Dodd-Frank Act, through the supervisory authority of the CFPB, which has the authority to regulate consumer financial products such as education loans, and to take enforcement actions against institutions that act as service providers to originators and processers of education loans, such as our subsidiaries FMER and Cology LLC; • Applicable laws and regulations, which may affect the terms upon which lenders agree to make education loans, the terms of future portfolio funding transactions, including disclosure and risk retention requirements, recovery rates on defaulted education loans and the cost and complexity of our loan facilitation operations; and • Departures or long-term unavailability of key personnel. Results of Operations-Fiscal Years ended June 30, 2014, June 30, 2013 and June 30, 2012 The financial results of operations include FMD and its subsidiaries for the fiscal years then ended. The results of Union Federal, for all fiscal years presented, as well as previously consolidated securitization trusts and the results of FMD's subsidiary First Marblehead Data Services, Inc., or FMDS, for the fiscal year ended June 30, 2012, are included in discontinued operations as discussed below. Discontinued Operations Union Federal On May 28, 2014, the Union Federal Board of Directors approved the dissolution of Union Federal and authorized Union Federal to prepare a plan of voluntary dissolution, which plan is subject to the approval of the Union Federal Board of Directors, the OCC, and FMD, as the sole stockholder of Union Federal. Also on May 28, 2014, the FMD Board of Directors approved Union Federal's plan to pursue the dissolution of Union Federal and to prepare the plan of voluntary dissolution, which plan is subject to the approval of FMD, as the sole stockholder of Union Federal. Following the dissolution of Union Federal, FMD will cease to offer banking services through Union Federal. The voluntary dissolution plan will outline management's intention to sell the assets of Union Federal, consisting primarily of its education loan, mortgage loan and investment portfolios, and settling its customer deposits at the earlier of maturity or the effectiveness of the dissolution. In addition to the exit costs discussed in Note 3, "Discontinued Operations-Union Federal," in the notes to our consolidated financial statements included in Item 8 of this annual report, we expect to incur charges related to lease obligations, legal fees and contract termination provisions in connection with the voluntary dissolution plan. Furthermore, depending on the timing and extent of the dissolution process, FMD may purchase certain assets from Union Federal or advance funds to facilitate deposit redemptions on a temporary basis before the assets are ultimately liquidated. We expect the dissolution process to be complete by the end of fiscal 2015. As a result of the foregoing and our evaluation under ASC 205-20, we reported the operations and activities relating to Union Federal within discontinued operations for fiscal 2014, fiscal 2013 and fiscal 2012. See Note 3, "Discontinued Operations-Union Federal," in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information. 56 -------------------------------------------------------------------------------- Table of Contents Securitization Trusts and FMDS Upon our adoption of ASU 2009-16 and ASU 2009-17, effective July 1, 2010, we consolidated 14 securitization trusts that we facilitated during fiscal 2004 through fiscal 2008. The education loans purchased by certain of the securitization trusts , which we refer to as the Trusts, were initially subject to a default repayment guaranty by The Education Resources Institute, Inc., or TERI, while the education loans purchased by other securitization trusts, which we refer to as the NCT Trusts, were, with limited exceptions, not TERI-guaranteed. Of the 14 securitization trusts consolidated on July 1, 2010, 11 were Trusts and three were NCT Trusts. We refer to the consolidated Trusts as the NCSLT Trusts and the consolidated NCT Trusts as the GATE Trusts. Consistent with our goal of refining our business model and focusing on our Monogram platform and tuition billing and payment processing services, we disposed of certain components of our business in fiscal 2012. In particular, we sold our remaining variable interests in the Trusts, we sold our trust administrator, FMDS, and we resigned as the special servicer of the Trusts, including the NCSLT Trusts. In addition, the new third-party owner of FMDS terminated the agreement, effective September 30, 2012, with FMD's subsidiary FMER for the special servicing of the NCT Trusts, including the GATE Trusts. During the fourth quarter of fiscal 2012, we determined that we no longer had any significant continuing involvement in the operations relating to the NCSLT Trusts and the GATE Trusts. Further, we concluded that this would occur within an appropriate assessment period for both the NCSLT Trusts and the GATE Trusts. As a result, we reported the operations and activities relating to the NCSLT Trusts, the GATE Trusts and FMDS within discontinued operations for fiscal 2012. See Note 3, "Discontinued Operations-Securitization Trusts and First Marblehead Data Services, Inc.," in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information. Overall Results The following table summarizes the results of our consolidated operations: Change between periods Fiscal years ended June 30, better (worse) 2014 2013 2012 2014 - 2013 2013 - 2012 (dollars in thousands) Revenues: Tuition payment processing fees $ 28,186 $ 26,668 $ 26,544 $ 1,518 $ 124 Administrative and other fees 13,640 11,238 9,778 2,402 1,460 Fair value changes to service revenue receivables 2,330 2,068 947 262 1,121 Total revenues 44,156 39,974 37,269 4,182 2,705 Total expenses 83,880 91,267 101,046 7,387 9,779 Total other income 784 2,461 12,688 (1,677 ) (10,227 ) Loss from continuing operations, before income taxes (38,940 ) (48,832 ) (51,089 ) 9,892 2,257 Income tax expense (benefit) from continuing operations 1,125 2,295 (17,956 ) 1,170 (20,251 ) Net loss from continuing operations (40,065 ) (51,127 ) (33,133 ) 11,062 (17,994 ) Discontinued operations, net of taxes 2,498 930 1,135,361 1,568 (1,134,431 ) Net (loss) income $ (37,567 ) $ (50,197 ) $ 1,102,228 $ 12,630 $ (1,152,425 ) The net loss from continuing operations for the fiscal year ended June 30, 2014 was $40.1 million, or $(3.55) per common share, compared to a net loss from continuing operations of $51.1 million, or $(4.77) per common share, for the fiscal year ended June 30, 2013. The improvement in the net loss year-over-year was 57 -------------------------------------------------------------------------------- Table of Contents attributable to a $4.2 million increase in total revenues, a $7.4 million decline in expenses and a $1.2 million decrease in income tax expense, partially offset by a decline in other income of $1.7 million. The net loss from continuing operations for the fiscal year ended June 30, 2013 was $51.1 million, or $(4.77) per basic common share, compared to a net loss from continuing operations of $33.1 million, or $(3.00) per basic common share, for the fiscal year ended June 30, 2012. The increase in the net loss year-over-year was primarily attributable to the results for fiscal 2012, which included significant benefits of $9.5 million related to the deconsolidation of the GATE Trusts, which is included in other income, as well as an income tax benefit from continuing operations of $18.0 million. The aggregate of these benefits was $27.5 million, or $2.49 per basic common share. Revenues Revenues include tuition payment processing fees earned by TMS, fee-for-service revenues for loan processing, origination and program support, fees for portfolio management services and fees related to our Monogram platform. Revenues also include fair value changes related to service revenue receivables. Revenues were $44.2 million for the fiscal year ended June 30, 2014, up $4.2 million from $40.0 million for the fiscal year ended June 30, 2013. The increase in revenues for the fiscal year ended June 30, 2014 included a $2.2 million increase in fee income from Cology LLC, an increase of $1.6 million in Monogram-based fee revenues, an increase of $1.5 million in tuition management fees and an increase of $1.2 million in fees for portfolio management services. These increases were partially offset by $2.0 million in lower revenues from special servicing. Cology LLC completed its acquisition of a substantial portion of the operating assets of the Cology Sellers in October 2012 and, as a result, the fiscal year ended June 30, 2013 included fee income only for the period from the date of acquisition through June 30, 2013. The increase in Monogram-based fee revenues was primarily the result of increased loan portfolio balances at our partner lender clients. Due to the nature of the recurring fee structure under our Monogram-based programs, our Monogram-based fee income increases as portfolio sizes at our partner lender clients grow. The increase in tuition management fees was primarily due to increased credit card payment processing. The increase in portfolio management services fees was due to an increase in new clients as well as fees received for certain one-time services performed. Revenues were $40.0 million for the fiscal year ended June 30, 2013, up $2.7 million from $37.3 million for the fiscal year ended June 30, 2012. The increase from fiscal 2012 to fiscal 2013 was primarily related to $4.6 million in higher fee income related to our Monogram platform as a result of significantly higher partnered lending loan disbursements, the inclusion of $2.2 million of revenues from Cology LLC for loan processing and increases in the valuation of our service revenue receivables of $1.1 million, partially offset by $5.1 million in lower revenues from special servicing and transition services related to the FMDS sale. Fair value changes to service revenue receivables We record our service revenue receivables at fair value on our consolidated balance sheets. At June 30, 2014, our service revenue receivables consisted of additional structural advisory fee and residual receivables and represented the estimated fair value of the service revenue receivables expected to be collected over the life of the various separate securitization trusts that have purchased education loans facilitated by us, with no further service obligations on our part. Changes in the estimated fair value of the service revenue receivables due, less any cash distributions received, are recorded in our consolidated statements of operations within fair value changes to service revenue receivables. In the absence of market-based transactions, we use cash flow modeling techniques to derive an estimate of fair value for financial reporting purposes. Significant observable and unobservable inputs used to develop our fair value estimates include, but are not limited to, recovery, default and prepayment rates, discount rates and the forward LIBOR curve. See Note 9, "Fair Value Measurements," in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information. 58-------------------------------------------------------------------------------- Table of Contents Expenses The following table reflects the composition of expenses: Change between periods Fiscal years ended June 30, better (worse) 2014 2013 2012 2014 - 2013 2013 - 2012 (dollars in thousands) Compensation and benefits $ 36,251 $ 39,317 $ 41,145 $ 3,066 $ 1,828 General and administrative: Third-party services 14,689 14,651 15,907 (38 ) 1,256 Depreciation and amortization 5,288 4,347 4,615 (941 ) 268 Marketing 1,799 5,123 8,470 3,324 3,347 Occupancy and equipment 10,856 11,379 10,913 523 (466 ) Servicer fees 278 650 696 372 46 Merchant fees 7,773 6,663 6,467 (1,110 ) (196 ) Trust related special servicing expenses - 1,639 5,920 1,639 4,281 Other 6,946 7,498 6,913 552 (585 ) Total general and administrative 47,629 51,950 59,901 4,321 7,951 Total expenses $ 83,880 $ 91,267 $ 101,046 $ 7,387 $ 9,779 Total number of employees from continuing operations at fiscal year-end 281 289 293 Compensation and benefits Compensation and benefits expenses decreased to $36.3 million in fiscal 2014 from $39.3 million in fiscal 2013. The decrease of $3.0 million year-over-year was primarily driven by $2.1 million in lower salary expense due to a decline in average headcount and $1.2 million in lower severance-related costs. Compensation and benefits expenses decreased to $39.3 million in fiscal 2013 from $41.1 million in fiscal 2012. The decrease of $1.8 million year-over-year was primarily due to approximately $700 thousand in lower severance related costs, $534 thousand in lower non-cash compensation and a $470 thousand decrease in salary expense as a result of an increase in costs capitalized for internally developed software. These decreases were partially offset by $348 thousand in higher variable sales compensation. Total headcount decreased in fiscal 2013 due to the implementation of certain expense reduction efforts. This decrease in headcount was largely offset by our hiring of 43 employees from the Cology Sellers in connection with the acquisition of a substantial portion of the operating assets of the Cology Sellers as of October 19, 2012. General and administrative expenses General and administrative expenses decreased to $47.6 million in fiscal 2014 from $51.9 million in fiscal 2013. The decrease of $4.3 million was primarily driven by a $3.3 million decline in marketing costs coupled with a $1.6 million decrease in trust-related special servicing expenses as a result of the cessation of our special servicing obligations for certain of the securitization trusts that we previously facilitated. These decreases were partially offset by increased merchant fee expenses related to payment processing services performed by TMS of $1.1 million. General and administrative expenses decreased to $51.9 million in fiscal 2013 from $59.9 million in fiscal 2012. The decrease of $8.0 million was largely driven by a decrease in trust related special servicing expenses, which declined $4.3 million year-over-year, primarily as a result of the cessation of our special servicing obligations for certain of the securitization trusts that we previously facilitated. Additionally, marketing costs decreased by $3.3 million year-over-year due to our investment in brand development of Union Federal's Monogram-based loan programs in fiscal 2012. 59-------------------------------------------------------------------------------- Table of Contents Other Income The following table reflects the components of other income: Fiscal years ended June 30, 2014 2013 2012 (dollars in thousands) Interest income $ 227 $ 473 $ 950 Interest expense (25 ) (124 ) (251 ) Net interest income 202 349 699 Gain from deconsolidation of trusts - - 9,514 Other income 582 2,112 2,475 Total other income $ 784 $ 2,461 $ 12,688 Net interest income Interest income primarily reflected interest earned on cash and cash equivalents and short-term investments of $213 thousand, $435 thousand and $468 thousand for fiscal 2014, fiscal 2013 and fiscal 2012, respectively. The remaining interest income related to interest earned on our interest-bearing restricted cash of $14 thousand, $38 thousand and $482 thousand for fiscal 2014, fiscal 2013 and fiscal 2012, respectively. The decrease in interest income from both fiscal 2013 to fiscal 2014 and fiscal 2012 to fiscal 2013 was the result of a decline in rates and, to a lesser extent, a decline in average balances held. Interest income for the fiscal years presented was partially offset by interest expense costs on various lease obligations. Gain from deconsolidation of trusts During fiscal 2012, we recorded income related to the deconsolidation of the securitization trusts previously consolidated of $9.5 million largely relating to the re-establishment of the fair value of the residual interests that were previously eliminated upon our adoption of ASU 2009-17 on July 1, 2010. Other income During fiscal 2014, we recorded other income of $582 thousand, consisting of $281 thousand in proceeds from the TERI settlement, discussed below, $225 thousand related to the sale of Cology LLC's loan servicing business and $76 thousand in cash recoveries on previously defaulted education loans held by FMD. During fiscal 2013, we recorded other income of $2.1 million, consisting of $702 thousand in proceeds from the TERI settlement, discussed below, $946 thousand related to the sale of a defaulted loan portfolio, which was transferred by Union Federal to an indirect subsidiary of FMD in 2009, and $464 thousand in cash recoveries on previously defaulted education loans held by FMD. During fiscal 2012, we recorded other income of $2.5 million, consisting of $1.6 million in proceeds from the TERI settlement, discussed below, and $790 thousand in cash recoveries on previously defaulted education loans held by FMD. The TERI settlement proceeds recognized in each fiscal year presented above are the result of the resolution of certain matters related to TERI's confirmed plan of reorganization. This income represented cash distributions from the liquidating trust under TERI's confirmed plan of reorganization. Income Taxes We are subject to federal income tax, as well as income tax in multiple U.S. state and local jurisdictions. Our effective income tax rate is calculated on a consolidated basis. The IRS is auditing our tax returns for fiscal 2007 through fiscal 2010. We also remain subject to federal income tax examinations for fiscal 2011 through fiscal 2013. In addition, we are involved in several matters relating to the Massachusetts tax treatment of GATE, a former subsidiary of FMD. See "-Internal Revenue Service Audit" below as well as Item 3, "Legal Proceedings," and Note 13, "Commitments and Contingencies-Income Tax Matters," in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information regarding these matters. 60-------------------------------------------------------------------------------- Table of Contents Our state income tax returns in jurisdictions other than Massachusetts remain subject to examination for various fiscal years ended between June 30, 2010 and June 30, 2014. Income tax expense from continuing operations for fiscal 2014 was $1.1 million as compared to an income tax expense of $2.3 million in fiscal 2013 and income tax benefit of $18.0 million in fiscal 2012. The decrease in income tax expense from fiscal 2013 to fiscal 2014 was due to additional state tax liability and accrued interest of approximately $1.0 million recognized in fiscal 2013 related to the case pertaining to our Massachusetts state income tax returns for the 2008 and 2009 tax years. The benefit in fiscal 2012 was primarily the result of the recognition of an income tax benefit of $12.5 million during the second quarter of fiscal 2012 in connection with the ATB Order, as well as the expiration of the statute of limitations applicable to GATE's taxable year ended June 30, 2007. In addition, a $5.7 million benefit was recorded in the third quarter of fiscal 2012 related to the gain on the sale of FMDS, which was included in discontinued operations. Beginning in fiscal 2011, we no longer had any taxable income in prior periods to offset current period net operating losses for federal income tax purposes. As a result, we recorded a net operating loss carryforward asset as of June 30, 2014 and June 30, 2013, totaling $58.1 million and $45.0 million, respectively, for which we recorded a full valuation allowance. Under current law, we do not have remaining taxes paid within available net operating loss carryback periods, and it is more likely than not that our deferred tax assets will not be realized through future reversals of existing temporary differences or available tax planning strategies. Accordingly, we have determined that a valuation allowance was necessary for all of our deferred tax assets not scheduled to reverse against existing deferred tax liabilities as of June 30, 2014 and June 30, 2013. We will continue to review the recognition of deferred tax assets on a quarterly basis. Internal Revenue Service Audit Effective March 31, 2009, we completed the sale of the Trust Certificate. In connection with the sale of the Trust Certificate, FMD entered into the Asset Services Agreement pursuant to which FMD provided various consulting and advisory services to the purchaser of the Trust Certificate. As a result of the sale of the Trust Certificate, as well as our operating losses incurred in fiscal 2009, we recorded an income tax receivable for federal income taxes paid on taxable income in prior fiscal years. In fiscal 2010, we received a total of $189.3 million in federal and state income tax refunds related to our income tax receivables. Furthermore, we received a federal income tax refund of $45.1 million in October 2010 related to the operating losses in fiscal 2010, which we applied to taxable income from fiscal 2008. In April 2010, the IRS commenced an audit of our tax returns for fiscal 2007 through fiscal 2009, including a review of the tax treatment of the sale of the Trust Certificate and the federal tax refund previously received in the amount of $176.6 million. Such audits are consistent with the practice of the Joint Committee of Taxation, which requires the IRS to perform additional procedures for a taxpayer who receives a tax refund in excess of $2.0 million, which may include an audit of such taxpayer's tax return. The IRS is also auditing our fiscal 2010 tax return in light of the $45.1 million income tax refund that we received in October 2010. We announced on August 15, 2013 that, as part of the audit process, we expected to receive a NOPA from the IRS. On September 10, 2013 we received two NOPAs from the IRS that contain the proposed adjustments that we announced on August 15, 2013. In the NOPAs, the IRS asserts that our sale of the Trust Certificate should not be recognized for federal income tax purposes primarily because we retained the economic benefits and burdens of the Trust Certificate, including, among other things, retaining certain repurchase rights and data rights. The IRS further concludes that the transaction should be characterized as a financing instead of a sale and asserts that the sale of the Trust Certificate and the execution of the Asset Services Agreement had the impact of converting taxable income to the owner from an accrual basis to a cash basis. As a result, the NOPAs propose to disallow the loss that generated the tax refunds that we previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS' positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal income tax adjustments 61 -------------------------------------------------------------------------------- Table of Contents that we estimate to be approximately $300.0 million, excluding interest until such matter is resolved and the assessment of penalties, if any. The NOPAs do not address tax years beyond June 30, 2011. The NOPAs are proposed recommendations of the reviewing agent in the IRS field office and, as such, are initial IRS positions and not final determinations, and, as a result, do not require any tax payment at the time of issuance. We have considered the requirements of ASC 740 and the impact of the NOPAs, along with other information supporting our overall tax position, in our assessment of the ultimate outcome of this matter with the IRS, and based on our analysis, we did not record an accrual related to this matter in our consolidated financial statements at June 30, 2014. Such an accrual, if it becomes necessary, could be significant and material to our consolidated financial statements. We are vigorously contesting the proposed adjustments with the IRS, and we continue to believe we have a strong position as it relates to this matter; however, we cannot predict the timing or outcome of the IRS audit. The process of resolving this issue, which may include an appeals process with the IRS and litigation in the U.S. Tax Court and the U.S. Court of Appeals, may extend over multiple years depending on how it progresses through the IRS and, if necessary, the courts. Assuming this matter advances unresolved through the IRS' administrative process and the courts, we are not required to make tax payments, if any, until the matter is fully resolved, which may be several years from now. However, if we receive an unfavorable outcome from the U.S. Tax Court and appeal, we must post a bond, which could have a significant cost and, depending on our financial condition, may not be obtainable, in order to prevent collection of the tax deficiency. Discontinued Operations, Net of Taxes The discontinued operations of Union Federal, net of taxes, for the fiscal year ended June 30, 2014 was $2.5 million, or $0.22 per common share, compared to $930 thousand, or $0.09 per common share, for the fiscal year ended June 30, 2013. The $1.6 million improvement year-over-year was primarily attributable to $2.1 million in gains on the sales of portfolios of education loans to Citizens and $600 thousand in increased net interest income, partially offset by other-than-temporary impairment losses on investments available-for-sale of $1.1 million. Discontinued operations, net of taxes, for the fiscal year ended June 30, 2012 of $1.1 billion primarily consisted of the operations and activities of the NCSLT Trusts, the GATE Trusts and FMDS. See Note 3, "Discontinued Operations," in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information. Financial Condition The changes in our financial condition from June 30, 2013 to June 30, 2014 are discussed below. The assets and liabilities of Union Federal have been segregated and reported as assets and liabilities of discontinued operations on our consolidated balance sheets. Continuing Operations Cash, Cash Equivalents and Short-term Investments We had combined cash, cash equivalents and short-term investments of $74.0 million and $113.8 million at June 30, 2014 and June 30, 2013, respectively, representing interest-bearing and non-interest-bearing deposits, money market funds and certificates of deposit with highly-rated financial institutions. The decrease of $39.8 million was primarily a result of $32.6 million to fund continuing operations, $2.7 million in additional deposits for participation accounts and $2.5 million for purchases of property and equipment. Restricted Cash At June 30, 2014, restricted cash on our consolidated balance sheets was $94.4 million, of which $93.9 million was held by TMS. Restricted cash at June 30, 2013 was $87.3 million, of which $86.7 million was held by TMS. The increase of $7.1 million from fiscal 2013 to fiscal 2014 in restricted cash was primarily due to the increased cash balance at TMS and timing of payments to educational institutions. 62 -------------------------------------------------------------------------------- Table of Contents Restricted cash held by TMS represents tuition payments collected from students or their families on behalf of educational institutions. These cash balances are held in escrow under a trust agreement for the benefit of TMS' educational institution clients and are generally subject to cyclicality, tending to peak in August of each school year, early in the enrollment cycle, and to decrease in May, the end of the school year. Over the last 12 months, TMS' restricted cash balances ranged from a high of $327.0 million during August 2013 to a low of $33.6 million during May 2014. Restricted cash held by Cology LLC represents loan origination proceeds which it collects and disburses on behalf of its lender clients. Restricted cash held by FMER relates to recoveries on defaulted education loans collected on behalf of clients as well as undistributed loan origination proceeds. We record a liability on our consolidated balance sheets representing tuition payments due to our TMS clients, loan origination proceeds due to our Cology LLC clients and recoveries on defaulted education loans and education loan proceeds due to schools. Deposits for Participation Interest Accounts We recorded deposits for participation accounts at fair value on our consolidated balance sheets. Deposits for participation accounts increased by $2.7 million from $13.1 million at June 30, 2013 to $15.8 million at June 30, 2014. The increase year-over-year was primarily attributable to increased fundings in fiscal 2014 due to an increase in disbursed loan volumes for our partner lender clients. These amounts excluded $7.4 million in participation account funds that are due back to FMD and which we reclassified from deposits for participation accounts to cash and cash equivalents on our consolidated balance sheet as of June 30, 2014. The return of funds resulted from the thirteenth amendment to the SunTrust Loan Program Agreement, which was effective June 1, 2014, pursuant to which the amount of credit enhancement required in the participation account was reduced and such fund were contractually due back to FMD on June 30, 2014. The refund, net of an additional deposit for new program year loan volume (defined as loans expected to be funded during the year subsequent to the thirteenth amendment effective date), was $7.4 million, which we received on July 25, 2014. Goodwill and Intangible Assets Goodwill represents the excess of the cost of an acquisition over the fair value of the net tangible and other intangible assets acquired. Other intangible assets represent purchased assets that can be distinguished from goodwill because of contractual rights or because the asset can be exchanged on its own or in combination with a related contract, asset or liability. In connection with our acquisition of assets from TMS and the Cology Sellers, we recorded other intangible assets related to the TMS customer list and tradename and the Cology Sellers customer list, each of which we amortize on a straight-line basis over 15 years, and TMS technology, which we amortize on a straight-line basis over six years. We record amortization expense in general and administrative expenses in our consolidated statements of operations. As it relates to TMS, the customer list intangible asset is related to educational institutions with which TMS had existing tuition programs in place as of December 31, 2010. The trade name intangible asset relates to the name and reputation of TMS in the tuition payment industry. Intangible assets attributable to technology represented the replacement cost of software and systems acquired that are necessary to support operations, net of an obsolescence factor. Goodwill represents the value ascribed to the acquisition of TMS that cannot be separately ascribed to a tangible or intangible asset. As it relates to Cology LLC, the customer list intangible asset is related to lender clients, including credit union and other lender clients, with which the Cology Sellers had existing loan origination and servicing programs in place as of October 19, 2012, the closing date of the acquisition. Goodwill represents the value ascribed to the acquisition of a substantial portion of the operating assets of the Cology Sellers that cannot be separately ascribed to a tangible or intangible asset. In fiscal 2014, we evaluated our goodwill for impairment on May 31, which is our annual impairment testing date, and concluded that the fair market values of the TMS and Cology LLC reporting units were approximately 42% and 38%, respectively, in excess of our recorded book value and, therefore, were not impaired as of that date. In determining whether impairment exists, we assess impairment at the level of the TMS and Cology LLC reporting units. There have been no indicators of impairment since that date. 63-------------------------------------------------------------------------------- Table of Contents Various assumptions go into our assessment of whether there is any goodwill impairment to be recorded. The more meaningful assumptions that contribute to the cash flow model used to determine the fair value of the TMS reporting unit include the net retention rate of new and existing clients, the penetration rate achieved in the overall customer portfolio, adoption of refund management and Student Account Center products and pricing, the level of interest income to be earned by TMS on funds received but not yet disbursed to client schools, including the forward LIBOR curve, the level of cash balances and the applicable hold periods, all of which impact net interest income, expense levels at TMS and the discount rate used to determine the present value of the cash flow streams. TMS' business would be adversely affected if any of the following were to occur: higher attrition rates than planned as a result of the competitive environment or our inability to provide products and services that are competitive in the marketplace, lower-than-planned adoption rates of refund management and Student Account Center products, higher-than-expected expense levels to provide services to TMS clients, a lower interest rate environment than depicted by the LIBOR curve, shorter hold periods or lower cash balances than contemplated, which would reduce our overall net interest income opportunity for cash that is held by us on behalf of TMS school clients, increases in equity returns required by investors and changes in our business model that may impact one or more of these variables. The more meaningful assumptions that contribute to the cash flow model used to determine the fair value of the Cology LLC reporting unit include loan volume growth, revenues related to the cross-selling of Monogram-based products and services, client attrition, costs required to support the assumed volume of the business and discount rates. Cology LLC's business would be adversely affected if any of the following were to occur: higher attrition rates than planned, a lack of acceptance of Monogram products and services by its credit union and other lender clients, higher-than-expected expense levels to provide services to Cology LLC clients and changes in our business model that may impact one or more of these variables. At June 30, 2014 our goodwill balance was $20.1 million, of which $19.5 million related to TMS and $518 thousand related to Cology LLC. At June 30, 2014, our net intangible assets balance was $21.8 million, of which $16.8 million related to TMS and $5.0 million related to Cology LLC. During the fiscal year ended June 30, 2014, we recorded amortization expense of $1.9 million related to TMS and $377 thousand related to Cology LLC. Discontinued Operations Cash and Cash Equivalents Union Federal held a total of $86.4 million in cash and cash equivalents as of June 30, 2014, an increase of $63.1 million from $23.3 million as of June 30, 2013. The increase year-over-year was primarily a result of $63.4 million in proceeds received on the sales of portfolios of education loans to Citizens in fiscal 2014. Investments Available-for-Sale Investments available-for-sale held by Union Federal are reported at fair value at our consolidated balance sheet dates. Investments available-for-sale principally consisted of mortgage-backed federal agency securities at June 30, 2014 and June 30, 2013. The investments available-for-sale decreased $22.5 million from $84.8 million at June 30, 2013 to $62.3 million at June 30, 2014 primarily due to $12.2 million of principal repayments received, a net decrease of $9.9 million from purchase and sale activity and $970 thousand in other-than-temporary impairment losses. Loans All loans held by Union Federal have been classified as held-for-sale and recorded at the lower of cost or fair value as of June 30, 2014. Education loans decreased $41.1 million from $63.0 million at June 30, 2013 to $21.9 million at June 30, 2014 primarily due to the sales of portfolios of education loans to Citizens in fiscal 2014, which totaled approximately $59.0 million in aggregate outstanding principal, partially offset by new loan originations. Mortgage loans increased $3.7 million from $12.6 million at June 30, 2013 to $16.3 million at June 30, 2014 primarily due to new loan originations. 64-------------------------------------------------------------------------------- Table of Contents Deposits Deposit liabilities held by Union Federal, comprised of demand deposits and time deposits, were $161.1 million and $164.0 million at June 30, 2014 and June 30, 2013, respectively. The decline year-over-year was primarily attributable to online competitors offering higher rates on money market deposits and local competitors offering higher rates on time deposits. See Note 3, "Discontinued Operations-Union Federal," in the notes to our consolidated financial statements included in Item 8 of this annual report for additional information. Contractual Obligations Our consolidated contractual obligations consist of commitments under operating leases. The following table below summarizes our contractual cash obligations related to continuing operations by period at June 30, 2014, excluding the offsetting effect of payments due to us under subleases: Payments due by period Less than More than Contractual obligations Total 1 year 1-3 years 3-5 years 5 years (dollarsin thousands) Operating lease obligations(1) $ 7,518 $ 3,691 $ 3,827 $ - $ - (1) For additional information on our operating leases, see Item 2, "Properties," in this annual report. Total Stockholders' Equity Total stockholders' equity decreased from $179.3 million at June 30, 2013 to $146.5 million at June 30, 2014 as a result of our net loss of $37.6 million, partially offset by the change in accumulated other comprehensive income of $1.0 million for the net unrealized gains on our investments available-for-sale portfolio and an increase of $4.4 million in additional paid-in capital primarily for stock compensation. Reverse Stock Split On November 12, 2013, the FMD stockholders approved a 1-for-10 reverse stock split of FMD's issued and outstanding shares of common stock, which was effected on December 2, 2013. The shares of common stock retained a par value of $0.01 per share. In addition, FMD's authorized shares of common stock were proportionately decreased from 250,000,000 shares to 25,000,000 shares. Accordingly, stockholders' equity reflects the impact of the reverse stock split by reclassifying from common stock to additional paid-in capital an amount equal to the par value of the decreased number of shares issued resulting from the reverse stock split. The impact on our consolidated balance sheet was a decrease of $1.1 million in common stock with an offsetting increase to additional paid-in capital. Off-Balance Sheet Arrangements We offer outsourcing services in connection with education loan programs, from program design through securitization of the education loans. We have historically structured and facilitated the securitization of education loans for our clients through a series of special purpose trusts. The principal uses of the securitization trusts we facilitated have been to generate sources of liquidity for our clients' and make available more funds to students and colleges. In accordance with the guidance in ASC 810, Consolidation, we do not consolidate these securitization trusts as we are not deemed to be the primary beneficiary. 65 -------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Sources and Uses of Cash The following is a discussion of sources and uses of cash on a U.S. generally accepted accounting principle, or GAAP, basis as presented in our consolidated statements of cash flows included in our consolidated financial statements included in Item 8 of this annual report. We also use a non-GAAP financial metric, "net operating cash usage," when evaluating our cash and liquidity position, discussed in detail under "-Non-GAAP Measure: Net Operating Cash Usage" below. Net cash used in operating activities from continuing operations for fiscal 2014 was $36.3 million, compared with net cash used in operating activities from continuing operations of $51.9 million for fiscal 2013. The $15.6 million decrease in net cash used was principally the result of an $11.1 million lower net loss from continuing operations coupled with a decline in the net funding of participation accounts of $6.4 million and an overall reduction of $2.9 million in accounts payable funding. This was partially offset by increased funding for other assets as compared to the prior year. We anticipate continuing to receive fees related to loan processing and origination and portfolio management services as well as fees related to Monogram-based loan programs. We believe that our cash, cash equivalents and short-term investments, coupled with the management of our expenses and these fees, will be adequate to fund our operating losses in the short term as we seek to expand our client and revenue base over the short and long term. We are uncertain, however, as to whether we will be successful in selling our Monogram platform to additional lenders or how much loan volume may be originated by current or any additional lenders in the future. Net cash provided by investing activities from continuing operations for fiscal 2014 was $12.3 million compared with net cash used in investing activities of $24.1 million for fiscal 2013. The improvement of $36.4 million was the result of a $40.1 million increase in restricted cash and restricted funds due to clients due to the return of a $40.0 million deposit to TMS from Union Federal in fiscal 2013, an increase of $5.3 million in capital contributions to Union Federal and $4.7 million of net cash paid for the acquisition of a substantial portion of the operating assets of the Cology Sellers in fiscal 2013. This was partially offset by a reduction in the net proceeds received from short-term investments of $14.7 million. Net cash used in financing activities from continuing operations was $717 thousand for fiscal 2014 compared to net cash used in financing activities of $338 thousand during fiscal 2013. The increase in net cash used in financing activities was primarily due to increased repurchases of common stock during fiscal 2014. The OCC regulates all capital distributions by Union Federal directly or indirectly to us, including dividend payments. Union Federal is required to file a notice with the OCC at least 30 days before the proposed declaration of a dividend or approval of a proposed capital distribution by the Union Federal Board of Directors. Union Federal must file an application to receive the approval of the OCC for a proposed capital distribution when, among other circumstances, the total amount of all capital distributions (including the proposed capital distribution) for the applicable calendar year exceeds net income for that year to date plus the retained net income for the preceding two years. A notice or application to make a capital distribution by Union Federal may be disapproved or denied by the OCC if it determines that, after making the capital distribution, Union Federal would fail to meet minimum required capital levels or if the capital distribution raises safety or soundness concerns or is otherwise restricted by statute, regulation or agreement between Union Federal and the OCC or a condition imposed by an OCC agreement. Under the Federal Deposit Insurance Corporation Improvement Act, or FDICIA, an FDIC-insured depository institution such as Union Federal is prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become "undercapitalized" (as such term is used in the FDICIA). Sources and Uses of Liquidity We expect to fund our short-term liquidity requirements primarily through cash and cash equivalents and revenues from operations, and we expect to fund our long-term liquidity requirements through a combination of 66-------------------------------------------------------------------------------- Table of Contents revenues from operations and various financing vehicles available to us. We may also utilize issuances of common stock, promissory notes or other securities or the potential sale of certain assets of FMD. We expect to assess our financing alternatives periodically and access the capital markets opportunistically. If our existing resources are insufficient to satisfy our liquidity requirements, or if we were to enter into a strategic arrangement with another company, we may need to sell additional equity or debt securities. Any sale of additional equity or convertible debt securities may result in additional dilution to our stockholders, and we cannot be certain that additional public or private financing will be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain this additional financing, we may be required to further delay, reduce the scope of or eliminate one or more aspects of our operational activities, which could harm our business. Our liquidity and capital funding requirements may depend on a number of factors, including: • Cash necessary to fund our operations, including the operations of TMS and Cology LLC, and capital expenditures; • The extent to which our services and products, including our Monogram platform, TMS offerings and Cology LLC offerings, gain market share and remain competitive at pricing levels favorable to us; • The results of the audit conducted by the IRS of our tax returns for fiscal 2007 through fiscal 2010, which could result in challenges to tax refunds previously received in the amounts of $176.6 million in connection with our sale of the Trust Certificate and the $45.1 million income tax refund received in October 2010. In connection with the IRS audit, on September 10, 2013, we received two NOPAs from the IRS that contain the proposed adjustments that we announced on August 15, 2013. The NOPAs propose to disallow the loss that generated the tax refunds that we previously received as well as require us to include income from the Trust Certificate from the March 31, 2009 sale date through June 30, 2011 in our taxable income for such years. If the IRS' positions are successful, the disallowance of the loss, coupled with the additional taxable income after the sale date through June 30, 2011, would create federal income tax adjustments that we estimate to be approximately $300.0 million, excluding interest until such matter is resolved and the assessment of penalties, if any; • The profitability of our Monogram platform, which is dependent on, among other things, the amount of loan volume our lender clients are able to generate and costs incurred to acquire such volume; • The extent to which we fund credit enhancement arrangements or contribute to credit facility providers in connection with our Monogram platform; • The ability to effectively and efficiently manage our expense base; • The resolution of our appeal of the ATB Order, which could also affect our state tax liabilities for fiscal 2008 and fiscal 2009; and • The timing, size, structure and terms of any securitization or other funding transactions that we structure, as well as the composition of the loan pool being securitized or sold. Liquidity is required for capital expenditures, working capital, business development expenses, business acquisitions, income tax payments, costs associated with alternative financing transactions, general corporate expenses, capital provided in connection with Monogram-based loan program credit enhancement arrangements or capital markets transactions. In order to preserve capital and maximize liquidity in challenging market conditions, we have in the past taken certain broad measures to reduce the risk related to education loans and residual receivables on our consolidated balance sheet, change our fee structure, add new products and reduce our overhead expenses. In addition, the FMD Board of Directors has eliminated regular quarterly cash dividends for the foreseeable future. Restricted Funds Due to Clients As part of our operations, we have cash that is recorded as restricted cash on our consolidated balance sheets because it is deposited with third party institutions and not available for our use. Included in restricted cash on our consolidated balance sheets are tuition payments due to schools, undisbursed loan origination proceeds and 67 -------------------------------------------------------------------------------- Table of Contents recoveries on defaulted education loans. We record a liability on our consolidated balance sheets representing tuition payments due to our TMS clients, loan origination proceeds due to our Cology LLC clients and recoveries on defaulted education loans and education loan proceeds due to schools. Non-GAAP Measure: Net Operating Cash Usage In addition to providing financial measurements based on GAAP, we present below an additional financial metric that we refer to as "net operating cash usage" that was not prepared in accordance with GAAP. We define "net operating cash usage" to approximate cash requirements to fund our operations. "Net operating cash usage" is not directly comparable to our consolidated statements of cash flows prepared in accordance with GAAP. Legislative and regulatory guidance discourage the use of, and emphasis on, non-GAAP financial metrics and require companies to explain why a non-GAAP financial metric is relevant to management and investors. Management and the FMD Board of Directors use this non-GAAP financial metric, in addition to GAAP financial measures, as a basis for measuring and forecasting our core operating performance and comparing such performance to that of prior periods. This non-GAAP financial measure is also used by us in our financial and operational decision-making. We believe that the inclusion of this non-GAAP financial metric helps investors to gain a better understanding of our results, including our expenses and liquidity position. In addition, our presentation of this non-GAAP financial measure is consistent with how we expect that analysts may calculate their estimates of our financial results in their research reports and with how clients, investors, analysts and financial news media may evaluate our financial results. There are limitations associated with reliance on any non-GAAP financial measure because any such measure is specific to our operations and financial performance, which makes comparisons with other companies' financial results more challenging. Nevertheless, by providing both GAAP and non-GAAP financial measures, we believe that investors are able to compare our GAAP results to those of other companies, while also gaining a better understanding of our operating performance, consistent with management's evaluation. "Net operating cash usage" should be considered in addition to, and not as a substitute for, or superior to, financial information prepared in accordance with GAAP. "Net operating cash usage" excludes the effects of income taxes, acquisitions or divestitures, participation account net fundings and changes in other assets and other liabilities that are solely related to short-term timing of cash payments or receipts. In accordance with the requirements of Regulation G promulgated by the SEC, the table below presents the most directly comparable GAAP financial measure, loss from continuing operations, before income taxes, for the twelve months ended June 30, 2014 and June 30, 2013, and reconciles the GAAP measure to the comparable non-GAAP financial metric: Twelve Months Ended June 30, 2014 2013 (dollars in thousands) Loss from continuing operations, before income taxes $ (38,940 ) $ (48,832 ) Adjustments to loss from continuing operations, before income taxes: Fair value changes to service revenue receivables (2,330 ) (2,068 ) Cash distributions from service revenue receivables 3,168 3,592 Depreciation and amortization 5,288 4,347 Stock-based compensation 4,400 4,209 Changes in TMS deferred revenue (293 ) (496 ) Additions to property and equipment (2,506 ) (3,465 ) Other, net of cash flows from Union Federal 2,817 228 Non-GAAP net operating cash usage $ (28,396 ) $ (42,485 ) 68 -------------------------------------------------------------------------------- Table of Contents "Net operating cash usage" for the fiscal year ended June 30, 2014 was $28.4 million, a $14.1 million, or 33%, reduction compared to the fiscal year ended June 30, 2013. The decrease of $14.1 million for fiscal 2014 as compared to fiscal 2013 was largely the result of a decrease in cash expenses of $8.6 million driven principally by decreases of $5.6 million in general and administrative expenses coupled with a decrease of $3.0 million in compensation and benefits expenses. "Net operating cash usage" for the fiscal year ended June 30, 2014 included $4.2 million in cash generated from Union Federal, of which $2.1 million related to gains on the sales of portfolios of education loans to Citizens. We expect our "net operating cash usage" to be slightly adversely impacted by the absence of cash flows from Union Federal upon dissolution. Support of Subsidiary Bank Union Federal is a federally-chartered thrift that is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can result in initiation of certain mandatory and possibly additional discretionary actions by the regulators that, if undertaken, could have a direct material effect on our liquidity. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Union Federal must meet specific capital guidelines that involve quantitative measures of Union Federal's assets and liabilities as calculated under regulatory accounting practices. The capital amounts and classifications, however, are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Union Federal's equity capital was $26.0 million at June 30, 2014, up from $21.6 million at June 30, 2013. Quantitative measures established by regulation to ensure capital adequacy require Union Federal to maintain minimum amounts and ratios of total capital and Tier 1 capital to risk-weighted assets (each as defined in the regulations). As of June 30, 2014 and June 30, 2013, Union Federal was well capitalized under the regulatory framework for prompt corrective action. Union Federal's regulatory capital ratios were as follows as of the dates below: Regulatory Guidelines June 30, Well Minimum Capitalized 2014 2013 Capital ratios: Tier 1 risk-based capital 4.0 % 6.0 % 59.6 % 25.2 % Total risk-based capital 8.0 10.0 59.5 26.0 Tier 1 (core) capital 4.0 5.0 13.5 11.7 FMD is subject to regulation, supervision and examination by the Federal Reserve, as a savings and loan holding company, and Union Federal is subject to regulation, supervision and examination by the OCC. In March 2010, the FMD Board of Directors adopted resolutions required by the OTS, Union Federal's regulator at that time, undertaking to support the implementation by Union Federal of its business plan, so long as Union Federal is owned or controlled by FMD, and to notify the OTS (and now the OCC effective in fiscal 2012) in advance of any distributions to FMD stockholders in excess of $1.0 million per fiscal quarter and any incurrence or guarantee of debt in excess of $5.0 million. These resolutions continue to be applied by the Federal Reserve. Distribution to FMD stockholders may be further restricted by the Federal Reserve's required approval in those instances when such distributions exceed the net earnings of the prior 12-month period. On May 28, 2014, the Union Federal Board of Directors approved the dissolution of Union Federal and authorized Union Federal to prepare a plan of voluntary dissolution, which plan is subject to the approval of the Union Federal Board of Directors, the OCC and FMD, as the sole stockholder of Union Federal. Also on May 28, 2014, the FMD Board of Directors approved Union Federal's plan to pursue the dissolution of Union Federal and to prepare the plan of voluntary dissolution, which plan is subject to the approval of FMD, as the sole stockholder of Union Federal. Following the dissolution of Union Federal, FMD will cease to be a savings and loan holding company subject to regulation, supervision and examination by the Federal Reserve. 69-------------------------------------------------------------------------------- Table of Contents Inflation Inflation was not a material factor in either revenues or operating expenses during the periods presented. Critical Accounting Policies and Estimates Our consolidated financial statements have been prepared in accordance with GAAP. The preparation of our consolidated financial statements requires management to make estimates, assumptions and judgments that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at the date of our consolidated financial statements, as well as the reported amounts of revenues and expenses during the reporting period. We base our estimates, assumptions and judgments on our historical experience, economic conditions and on various other factors that we believe are reasonable under the circumstances. Actual results may differ from these estimates under varying assumptions or conditions. Our significant accounting policies are more fully described in Note 2, "Summary of Significant Accounting Policies," in the notes to our consolidated financial statements included in Item 8 of this annual report. On an ongoing basis, we evaluate our estimates and judgments, particularly as they relate to accounting policies that we believe are most important to the portrayal of our financial condition and results of operations. We regard an accounting estimate or assumption underlying our consolidated financial statements to be a "critical accounting estimate" where: • The nature of the estimate or assumption is material due to the level of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change; and • The impact of the estimates and assumptions on our financial condition or operating performance is material. We have discussed our accounting policies with the Audit Committee of the FMD Board of Directors. We consider the following to be our critical accounting policies: • Income taxes relating to uncertain tax positions under ASC 740; and • The determination of goodwill and other intangible asset impairment. Income Taxes Certain areas of accounting for income taxes require management's judgment, including determining the adequacy of liabilities for uncertain tax positions. Uncertain tax positions that meet the more likely than not recognition threshold are measured to determine the amount of benefit to recognize. An uncertain tax position is measured at the largest amount of benefit that management believes has a greater than 50% likelihood of realization upon settlement. Tax benefits not meeting our realization criteria represent unrecognized tax benefits. Judgments are made regarding various tax positions, which are often subjective and involve assumptions about items that are inherently uncertain. If actual factors and conditions differ materially from estimates made by management, the actual realization of liabilities for uncertain tax positions could vary materially from the amounts previously recorded. Deferred tax assets arise from items that may be used as a tax deduction or credit in future income tax returns, for which a financial statement tax benefit has already been recognized. The realization of the net deferred tax asset generally depends upon future levels of taxable income and the existence of prior years' taxable income to which refund claims could be carried back. Valuation allowances are recorded against those deferred tax assets determined not likely to be realized. Deferred tax liabilities represent items that will require a future tax payment. They generally represent tax expense recognized in our consolidated financial statements for which payment has been deferred, or a deduction taken on our tax return but not yet recognized as an expense in our consolidated financial statements. 70-------------------------------------------------------------------------------- Table of Contents Review of Goodwill and Intangible Assets for Impairment On December 31, 2010, we completed our acquisition of the assets, liabilities and operations of TMS, formerly a division of KeyBank National Association. On October 19, 2012, Cology LLC acquired a substantial portion of the operating assets, and assumed certain liabilities, of the Cology Sellers. As a result of these acquisitions, we recorded goodwill and intangible assets. We test goodwill for impairment annually and more frequently if circumstances warrant. Intangible assets acquired consist of the TMS customer lists, technology and tradename and the Cology Sellers customer list. The values of these intangible assets were estimated using valuation techniques, based on discounted cash flow analysis. These intangible assets are being amortized over the period the assets are expected to contribute to our cash flows. These intangible assets are subject to impairment tests in accordance with GAAP, generally, whenever events or changes in circumstances indicate that their carrying amount may not be fully recoverable. We evaluate goodwill for impairment by comparing the fair values of the operations of the TMS and Cology LLC reporting units to their carrying values, including goodwill. If the fair value of the reporting unit exceeds the carrying value, goodwill is not deemed to be impaired. If the fair value is less than the carrying value, a further analysis is required to determine the amount of impairment, if any. There are significant judgments involved in determining the fair values of the TMS and Cology LLC reporting units, including assumptions regarding the estimates of future cash flows from existing and new business activities, customer relationships, the value of existing customer contracts and the value of other intangible assets, as well as assumptions regarding what we believe a third party is willing to pay for all of the assets and liabilities of TMS and Cology LLC. The calculation also requires us to estimate the appropriate discount and growth rates to apply to those projected cash flows and an appropriate control premium to apply to arrive at a final fair value. Since the businesses are not publicly traded, and often there is not comparable market data available, there is a higher degree of judgment applied and the use of cash flows is weighted more heavily than the use of market multiples. In the event that we determine that our goodwill or intangible assets are impaired, the recognition of an impairment charge could have an adverse impact on our results of operations in the period that the impairment occurred or on our financial position. For fiscal 2014 and fiscal 2013, we recorded no goodwill impairment. We evaluated goodwill for impairment at our annual impairment testing date of May 31. |