Filed Pursuant to Rule 424(b)4
Registration Number 333-113493
PROSPECTUS
12,000,000 SHARES
LUMINENT LOGO
COMMON STOCK
We are offering 12,000,000 shares of our common stock. We will receive all
of the net proceeds from the sale of these shares. Our common stock is subject
to transfer restrictions designed to preserve our status as a real estate
investment trust, or REIT.
Our common stock is listed on the New York Stock Exchange, or NYSE, under
the symbol "LUM." On March 29, 2004, the last reported sale price of our common
stock on the NYSE was $14.30 per share.
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INVESTING IN OUR COMMON STOCK INVOLVES RISKS. SEE "RISK FACTORS"
BEGINNING ON PAGE 11 FOR A DISCUSSION OF RISKS RELATING TO OUR COMMON STOCK,
INCLUDING, AMONG OTHERS:
- We commenced operations in June 2003 and have a limited operating history.
Our manager, Seneca Capital Management LLC, or Seneca, has limited
experience managing a REIT. Accordingly, we might not be able to operate
our business or implement our operating policies and strategies
successfully.
- We have not identified any specific mortgage-backed securities to acquire
with the net proceeds of this offering. Accordingly, you will not have the
opportunity to review the assets we will acquire with the net proceeds of
this offering prior to your investment. In addition, we may not be able to
acquire such assets on a timely basis or upon favorable terms.
- We may enter into ineffective derivative transactions or other hedging
activities that may reduce our net interest income or cause us to suffer
losses.
- Interest rate mismatches between our mortgage-backed securities and our
borrowings used to fund our purchases of mortgage-backed securities might
reduce our net income or result in a loss during periods of changing
interest rates.
- Increased levels of prepayments on the mortgages underlying our
mortgage-backed securities might decrease our net interest income or
result in a net loss.
- We generally seek to borrow eight to 12 times the amount of our equity.
Such leveraging could reduce our net income and our cash available for
distributions or cause us to suffer losses.
- Our investment strategy permits us to invest up to 10% of our assets in
unrated mortgage-related assets, including mortgage-backed securities
rated below investment grade. These assets carry an increased likelihood
of default or rating downgrade relative to investment-grade assets, which
may cause us to suffer losses.
- Our board of directors may change our operating policies and strategies
without prior notice to you or stockholder approval and such changes could
harm our business and results of operations and the value of our stock.
- Our results may suffer as a consequence of a potential conflict of
interest arising out of our relationship with Seneca, on the one hand, and
Seneca's relationship with other third parties, on the other hand. In
addition, this potential conflict may reduce the amount of time and effort
that Seneca devotes to managing our business and may result in suitable
investment opportunities being allocated to other entities.
- We pay Seneca incentive compensation based on our portfolio's performance.
Accordingly, Seneca may recommend riskier or more speculative investments
in an effort to maximize its incentive compensation.
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PER SHARE TOTAL
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Public offering price....................................... $14.00 $168,000,000
Underwriting discounts and commissions...................... $ 0.84 $ 10,080,000
Proceeds, before expenses, to us............................ $13.16 $157,920,000
We have granted the underwriters a 30-day option to purchase up to an
additional 1,800,000 shares of common stock to cover over-allotments, if any. We
expect the shares of our common stock will be ready for delivery to purchasers
on or about April 2, 2004.
NEITHER THE SECURITIES AND EXCHANGE COMMISSION NOR ANY STATE SECURITIES
COMMISSION HAS APPROVED OR DISAPPROVED OF THESE SECURITIES OR DETERMINED IF THIS
PROSPECTUS IS TRUTHFUL OR COMPLETE. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
FRIEDMAN BILLINGS RAMSEY
CREDIT SUISSE FIRST BOSTON
JMP SECURITIES
FLAGSTONE SECURITIES
The date of this prospectus is March 29, 2004
YOU SHOULD RELY ONLY ON THE INFORMATION CONTAINED IN THIS DOCUMENT. WE HAVE
NOT AUTHORIZED ANYONE TO PROVIDE YOU WITH INFORMATION THAT IS DIFFERENT. THIS
DOCUMENT MAY BE USED ONLY WHERE IT IS LEGAL TO SELL THESE SECURITIES. THE
INFORMATION IN THIS DOCUMENT MAY BE ACCURATE ONLY ON THE DATE OF THIS DOCUMENT.
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TABLE OF CONTENTS
Summary..................................................... 1
Risk Factors................................................ 11
Cautionary Note Regarding Forward-Looking Statements........ 31
Use of Proceeds............................................. 32
Market Price of and Distributions on Our Common Stock....... 33
Capitalization.............................................. 36
Dilution.................................................... 37
Business.................................................... 38
Selected Financial Data..................................... 51
Management's Discussion and Analysis of Financial Condition
and Results of Operations................................. 52
Quantitative and Qualitative Disclosures about Market
Risk...................................................... 64
Conflicts of Interests; Certain Relationships and Related
Transactions.............................................. 69
The Manager................................................. 70
Management of the Company................................... 79
United States Federal Income Tax Considerations............. 91
Description of Capital Stock................................ 104
Certain Provisions of Maryland Law and of Our Charter and
Bylaws.................................................... 108
Common Stock Available For Future Sale...................... 113
Principal Stockholders...................................... 116
Underwriting................................................ 118
Legal Matters............................................... 121
Experts..................................................... 121
Where You Can Find More Information About Luminent Mortgage
Capital................................................... 121
Index to Financial Statements............................... F-1
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FOR PURCHASERS IN AUSTRIA ONLY: ANY PERSON WHO IS IN POSSESSION OF THIS
OFFERING CIRCULAR UNDERSTANDS THAT NO ACTION HAS BEEN OR WILL BE TAKEN WHICH
WOULD ALLOW AN OFFERING OF THE SHARES TO THE PUBLIC IN AUSTRIA. ACCORDINGLY, THE
SHARES MAY NOT BE OFFERED, SOLD OR DELIVERED AND NEITHER THIS OFFERING CIRCULAR
NOR ANY OTHER OFFERING MATERIALS RELATING TO THESE SECURITIES MAY BE DISTRIBUTED
OR MADE AVAILABLE TO THE PUBLIC IN AUSTRIA. ANY INDIVIDUAL SALES OF THESE
SECURITIES TO ANY PERSON IN AUSTRIA WERE MADE ONLY TO A LIMITED CIRCLE OF
INSTITUTIONAL INVESTORS IN ACCORDANCE WITH sec. 3/1/11 OF THE AUSTRIAN CAPITAL
MARKETS ACT OR IN A PRIVATE PLACEMENT WHERE A MAXIMUM OF 250 INDIVIDUALS WERE
INDIVIDUALLY APPROACHED AND IDENTIFIED BY NAME. THESE SECURITIES MUST NOT BE
RESOLD OR SOLD OTHER THAN IN COMPLIANCE WITH THE AUSTRIAN CAPITAL MARKETS ACT.
FOR PURCHASERS IN BELGIUM ONLY: THIS OFFERING CIRCULAR HAS NOT BEEN AND
WILL NOT BE REGISTERED WITH THE BELGIAN BANKING, FINANCE AND INSURANCE
COMMISSION ("BFIC"). THE SECURITIES OFFERING HAS NOT BEEN AND WILL NOT BE
APPROVED BY THE BFIC, AND THE TRANSACTION WILL NOT BE ADVERTISED IN BELGIUM. ANY
PERSON WHO IS IN POSSESSION OF THIS OFFERING CIRCULAR
i
UNDERSTANDS THAT NO ACTION HAS BEEN OR WILL BE TAKEN WHICH WOULD ALLOW AN
OFFERING OF THE SHARES TO THE PUBLIC IN BELGIUM. ACCORDINGLY, THE SHARES MAY NOT
BE OFFERED, SOLD OR DELIVERED AND NEITHER THIS OFFERING CIRCULAR NOR ANY OTHER
OFFERING MATERIALS RELATING TO THESE SECURITIES MAY BE DISTRIBUTED OR MADE
AVAILABLE TO THE PUBLIC IN BELGIUM. THE SECURITIES MUST NOT BE OFFERED,
DISTRIBUTED OR SOLD IN BELGIUM EXCEPT IN COMPLIANCE WITH THE REQUIREMENTS FOR A
NON-PUBLIC OFFERING LAID DOWN IN ARTICLES 2 AND 3 OF THE ROYAL DECREE OF 7 JULY
1999. INDIVIDUAL SALES OF THESE SECURITIES TO ANY PERSON IN BELGIUM MAY ONLY BE
MADE IF (i) NO UNAUTHORIZED INTERMEDIARY HAS BEEN INVOLVED, (ii) THE OFFER HAS
NOT BEEN ADVERTISED TO MORE THAN 50 INDIVIDUALS, AND (iii) A MAXIMUM OF 50
INDIVIDUALS HAS BEEN ACTIVELY SOLICITED. INDIVIDUAL SALES OF THESE SECURITIES TO
PROFESSIONAL INVESTORS, AS DEFINED IN ARTICLE 3 OF THE ROYAL DECREE OF 7 JULY
1999, ARE PERMITTED, AS WELL AS INDIVIDUAL SALES FOR A CONSIDERATION OF AT LEAST
EUR 250,000 PER INVESTOR.
FOR PURCHASERS IN CANADA ONLY:
OFFERS AND SALES IN CANADA
THIS OFFERING CIRCULAR IS NOT, AND UNDER NO CIRCUMSTANCES IS TO BE
CONSTRUED AS, AN ADVERTISEMENT OR A PUBLIC OFFERING OF SHARES OF THE COMPANY'S
COMMON STOCK IN CANADA OR ANY PROVINCE OR TERRITORY THEREOF. ANY OFFER OR SALE
OF SHARES OF THE COMPANY'S COMMON STOCK IN CANADA WILL BE MADE ONLY IN THE
PROVINCES OF QUEBEC, ONTARIO AND MANITOBA, ONLY UNDER AN EXEMPTION FROM THE
REQUIREMENTS TO FILE A PROSPECTUS WITH THE RELEVANT SECURITIES REGULATORS AND
ONLY BY A DEALER REGISTERED UNDER APPLICABLE PROVINCIAL SECURITIES LAWS OR,
ALTERNATIVELY, PURSUANT TO AN EXEMPTION FROM THE DEALER REGISTRATION REQUIREMENT
IN THE RELEVANT PROVINCE IN WHICH SUCH OFFER OR SALE IS MADE.
THIS OFFERING CIRCULAR IS FOR THE CONFIDENTIAL USE OF ONLY THOSE PERSONS TO
WHOM IT IS DELIVERED BY ANY UNDERWRITER OR DEALER IN CONNECTION WITH THE
OFFERING OF SHARES OF THE COMPANY'S COMMON STOCK IN THE PROVINCES OF QUEBEC,
ONTARIO AND MANITOBA. THE UNDERWRITERS AND THE DEALERS RESERVE THE RIGHT TO
REJECT ALL OR PART OF ANY OFFER TO PURCHASE SHARES OF THE COMPANY'S COMMON STOCK
FOR ANY REASON OR ALLOCATE TO ANY PURCHASER LESS THAN ALL OF THE SHARES OF THE
COMPANY'S COMMON STOCK FOR WHICH IT HAS SUBSCRIBED.
RESPONSIBILITY
EXCEPT AS OTHERWISE EXPRESSLY REQUIRED BY APPLICABLE LAW OR AS AGREED TO IN
CONTRACT, NO REPRESENTATION, WARRANTY OR UNDERTAKING (EXPRESS OR IMPLIED) IS
MADE AND NO RESPONSIBILITIES OR LIABILITIES OF ANY KIND OR NATURE WHATSOEVER ARE
ACCEPTED BY ANY UNDERWRITER OR DEALER AS TO THE ACCURACY OR COMPLETENESS OF THE
INFORMATION CONTAINED IN THIS OFFERING CIRCULAR OR ANY OTHER INFORMATION
PROVIDED BY THE COMPANY IN CONNECTION WITH THE OFFERING OF THE SHARES OF THE
COMPANY'S COMMON STOCK IN THE PROVINCES OF QUEBEC, ONTARIO AND MANITOBA.
ii
RESALE RESTRICTIONS
THE DISTRIBUTION OF THE SHARES OF THE COMPANY'S COMMON STOCK IN THE
PROVINCES OF QUEBEC, ONTARIO AND MANITOBA IS BEING MADE ON A PRIVATE PLACEMENT
BASIS ONLY AND IS EXEMPT FROM THE REQUIREMENT THAT THE COMPANY PREPARE AND FILE
A PROSPECTUS WITH THE RELEVANT SECURITIES REGULATORS. ACCORDINGLY, ANY RESALE OF
THE SHARES OF THE COMPANY'S COMMON STOCK MUST BE MADE IN ACCORDANCE WITH
APPLICABLE SECURITIES LAWS, WHICH REQUIRE RESALES TO BE MADE IN ACCORDANCE WITH
EXEMPTIONS FROM REGISTRATION AND PROSPECTUS REQUIREMENTS. CANADIAN PURCHASERS
ARE ADVISED TO SEEK LEGAL ADVICE PRIOR TO ANY RESALE OF THE SHARES OF THE
COMPANY'S COMMON STOCK.
REPRESENTATIONS OF PURCHASERS
EACH CANADIAN INVESTOR WHO PURCHASES SHARES OF THE COMPANY'S COMMON STOCK
WILL BE DEEMED TO HAVE REPRESENTED TO THE COMPANY, THE UNDERWRITERS AND ANY
DEALER WHO SELLS SHARES OF THE COMPANY'S COMMON STOCK TO SUCH PURCHASER THAT:
(I) THE OFFERING OF THE SHARES OF THE COMPANY'S COMMON STOCK WAS NOT MADE
THROUGH AN ADVERTISEMENT OF THE SHARES IN ANY PRINTED MEDIA OF GENERAL AND
REGULAR PAID CIRCULATION, RADIO, TELEVISION OR TELECOMMUNICATIONS, INCLUDING
ELECTRONIC DISPLAY, OR ANY OTHER FORM OF ADVERTISING IN CANADA; (II) SUCH
PURCHASER HAS REVIEWED THE TERMS REFERRED TO ABOVE UNDER "RESALE RESTRICTIONS";
(III) WHERE REQUIRED BY LAW, SUCH PURCHASER IS PURCHASING AS PRINCIPAL FOR ITS
OWN ACCOUNT AND NOT AS AGENT; (IV) SUCH PURCHASER, OR ANY ULTIMATE PURCHASER FOR
WHICH SUCH PURCHASER IS ACTING AS AGENT, IS ENTITLED UNDER APPLICABLE CANADIAN
SECURITIES LAWS TO PURCHASE SUCH SHARES OF THE COMPANY'S COMMON STOCK WITHOUT
THE BENEFIT OF A PROSPECTUS QUALIFIED UNDER SUCH SECURITIES LAWS AND WITHOUT
LIMITING THE GENERALITY OF THE FOREGOING: (A) IN THE CASE OF A PURCHASER LOCATED
IN A PROVINCE OTHER THAN ONTARIO, WITHOUT THE DEALER HAVING TO BE REGISTERED,
(B) IN THE CASE OF A PURCHASER LOCATED IN THE PROVINCE OF MANITOBA, SUCH
PURCHASER IS AN "ACCREDITED INVESTOR" AS DEFINED IN SECTION 1.1 OF MULTILATERAL
INSTRUMENT 45-103 -- CAPITAL RAISING EXEMPTIONS, (C) IN THE CASE OF A PURCHASER
LOCATED IN ONTARIO, SUCH PURCHASER, OR ANY ULTIMATE PURCHASER FOR WHICH SUCH
PURCHASER IS ACTING AS AGENT, IS AN "ACCREDITED INVESTOR", OTHER THAN AN
INDIVIDUAL, AS THAT TERM IS DEFINED IN ONTARIO SECURITIES COMMISSION RULE
45-501 -- EXEMPT DISTRIBUTIONS AND IS A PERSON TO WHICH A DEALER REGISTERED AS
AN INTERNATIONAL DEALER IN ONTARIO MAY SELL SHARES OF THE COMPANY'S COMMON
STOCK, AND (D) IN THE CASE OF A PURCHASER LOCATED IN QUEBEC, SUCH PURCHASER IS A
"SOPHISTICATED PURCHASER" WITHIN THE MEANING OF SECTION 44 OR 45 OF THE
SECURITIES ACT (QUEBEC).
TAXATION AND ELIGIBILITY FOR INVESTMENT
CANADIAN PURCHASERS OF SHARES OF THE COMPANY'S COMMON STOCK SHOULD CONSULT
THEIR OWN LEGAL AND TAX ADVISERS WITH RESPECT TO THE TAX CONSEQUENCES OF AN
INVESTMENT IN THE SHARES OF THE COMPANY'S COMMON STOCK IN THEIR PARTICULAR
CIRCUMSTANCES AND WITH RESPECT TO THE ELIGIBILITY OF THE SHARES OF THE COMPANY'S
COMMON STOCK FOR INVESTMENT BY THE PURCHASER UNDER RELEVANT CANADIAN FEDERAL AND
PROVINCIAL LEGISLATION AND REGULATIONS.
iii
RIGHTS OF ACTION FOR DAMAGES OR RESCISSION (ONTARIO PURCHASERS ONLY)
SECURITIES LEGISLATION IN ONTARIO PROVIDES THAT EVERY PURCHASER OF SHARES
OF THE COMPANY'S COMMON STOCK PURSUANT TO THIS OFFERING CIRCULAR SHALL HAVE A
STATUTORY RIGHT OF ACTION FOR DAMAGES OR RESCISSION AGAINST THE COMPANY IN THE
EVENT THIS OFFERING CIRCULAR CONTAINS A MISREPRESENTATION AS DEFINED IN THE
SECURITIES ACT (ONTARIO). ONTARIO PURCHASERS WHO PURCHASE SHARES OF THE
COMPANY'S COMMON STOCK OFFERED BY THIS OFFERING CIRCULAR DURING THE PERIOD OF
DISTRIBUTION ARE DEEMED TO HAVE RELIED ON THE MISREPRESENTATION IF IT WAS A
MISREPRESENTATION AT THE TIME OF PURCHASE. ONTARIO PURCHASERS WHO ELECT TO
EXERCISE A RIGHT OF RESCISSION AGAINST THE COMPANY ON WHOSE BEHALF THE
DISTRIBUTION IS MADE SHALL HAVE NO RIGHT OF ACTION FOR DAMAGES AGAINST THE
COMPANY. THE RIGHT OF ACTION FOR RESCISSION OR DAMAGES CONFERRED BY THE STATUTE
IS IN ADDITION TO, AND WITHOUT DEROGATION FROM, ANY OTHER RIGHT THE PURCHASER
MAY HAVE AT LAW. PROSPECTIVE ONTARIO PURCHASERS SHOULD REFER TO THE APPLICABLE
PROVISIONS OF ONTARIO SECURITIES LEGISLATION AND ARE ADVISED TO CONSULT THEIR
OWN LEGAL ADVISERS AS TO WHICH, OR WHETHER ANY, OF SUCH RIGHTS OR OTHER RIGHTS
MAY BE AVAILABLE TO THEM.
THE FOREGOING SUMMARY IS SUBJECT TO THE EXPRESS PROVISIONS OF THE
SECURITIES ACT (ONTARIO) AND THE RULES, REGULATIONS AND OTHER INSTRUMENTS
THEREUNDER, AND REFERENCE IS MADE TO THE COMPLETE TEXT OF SUCH PROVISIONS
CONTAINED THEREIN. SUCH PROVISIONS MAY CONTAIN LIMITATIONS AND STATUTORY
DEFENSES ON WHICH THE COMPANY MAY RELY. THE ENFORCEABILITY OF THESE RIGHTS MAY
BE LIMITED AS DESCRIBED BELOW UNDER "ENFORCEMENT OF LEGAL RIGHTS."
THE RIGHTS OF ACTION DISCUSSED ABOVE WILL BE GRANTED TO THE ONTARIO
PURCHASERS TO WHOM SUCH RIGHTS ARE CONFERRED UPON ACCEPTANCE BY THE UNDERWRITERS
OR THE RELEVANT DEALER OF THE PURCHASE PRICE FOR THE SHARES OF THE COMPANY'S
COMMON STOCK. THE RIGHTS DISCUSSED ABOVE ARE IN ADDITION TO AND WITHOUT
DEROGATION FROM ANY OTHER RIGHT OR REMEDY WHICH ONTARIO PURCHASERS MAY HAVE AT
LAW.
ENFORCEMENT OF LEGAL RIGHTS
ALL OF THE DIRECTORS AND OFFICERS OF THE COMPANY AS WELL AS THE EXPERTS
NAMED HEREIN, MAY BE LOCATED OUTSIDE OF CANADA AND, AS A RESULT, IT MAY NOT BE
POSSIBLE FOR ONTARIO PURCHASERS TO EFFECT SERVICE OF PROCESS WITHIN CANADA UPON
THE COMPANY OR SUCH PERSONS. ALL OR A SUBSTANTIAL PORTION OF THE ASSETS OF THE
COMPANY AND SUCH OTHER PERSONS MAY BE LOCATED OUTSIDE OF CANADA AND, AS A
RESULT, IT MAY NOT BE POSSIBLE TO SATISFY A JUDGMENT AGAINST THE COMPANY OR SUCH
PERSONS IN CANADA OR TO ENFORCE A JUDGMENT OBTAINED IN CANADIAN COURTS AGAINST
THE COMPANY OR SUCH PERSONS OUTSIDE OF CANADA.
LANGUAGE OF DOCUMENTS
UPON RECEIPT OF THIS DOCUMENT, YOU HEREBY CONFIRM THAT YOU HAVE EXPRESSLY
REQUESTED THAT ALL DOCUMENTS EVIDENCING OR RELATING IN ANY WAY TO THE SALE OF
THE SHARES OF THE COMPANY'S COMMON STOCK DESCRIBED HEREIN (INCLUDING FOR GREATER
CERTAINTY ANY PURCHASE CONFIRMATION OR ANY NOTICE) BE DRAWN UP IN THE ENGLISH
LANGUAGE ONLY. PAR LA RECEPTION
iv
DE CE DOCUMENT, VOUS CONFIRMEZ PAR LES PRESENTES QUE VOUS AVEZ EXPRESSEMENT
EXIGE QUE TOUS LES DOCUMENTS FAISANT FOI OU SE RAPPORTANT DE QUELQUE MANIERE QUE
CE SOIT A LA VENTE DES ACTIONS DECRITES AUX PRESENTES (INCLUANT, POUR PLUS DE
CERTITUDE, TOUTE CONFIRMATION D'ACHAT OU TOUT AVIS) SOIENT REDIGES EN ANGLAIS
SEULEMENT.
FOR PURCHASERS IN DENMARK ONLY: THIS OFFERING CIRCULAR HAS NOT BEEN AND
WILL NOT BE FILED WITH OR APPROVED BY THE DANISH SECURITIES COUNCIL
("FONDSRADET") OR ANY OTHER REGULATORY AUTHORITY IN THE KINGDOM OF DENMARK. THE
SHARES HAVE NOT BEEN OFFERED OR SOLD AND MAY NOT BE OFFERED OR SOLD OR DELIVERED
DIRECTLY OR INDIRECTLY IN DENMARK, UNLESS IN COMPLIANCE WITH CHAPTER 12 OF THE
DANISH ACT ON TRADING IN SECURITIES AS AMENDED FROM TIME TO TIME AND DANISH
EXECUTIVE ORDER NO. 166 OF 13 MARCH 2003 ON THE FIRST PUBLIC OFFER IN DENMARK OF
THE SHARES ISSUED PURSUANT TO THIS OFFERING CIRCULAR. THE RECIPIENT OF THIS
OFFERING CIRCULAR MAY NOT FORWARD ANY OFFER TO, OR REPLACE THEMSELVES WITH, ANY
OTHER INVESTOR IN DENMARK WITHOUT COMPLYING WITH THE RELEVANT LAWS.
FOR PURCHASERS IN FINLAND ONLY: THIS OFFERING CIRCULAR HAS NOT BEEN
PREPARED TO COMPLY WITH THE STANDARDS AND REQUIREMENTS APPLICABLE UNDER FINNISH
LAW, INCLUDING THE SECURITIES MARKET ACT (26.5.1989/495) AS AMENDED, AND THEY
HAVE NOT BEEN APPROVED BY THE FINNISH FINANCIAL SUPERVISION AUTHORITY. ANY
PERSON WHO IS IN POSSESSION OF THIS OFFERING CIRCULAR UNDERSTANDS THAT NO ACTION
HAS BEEN OR WILL BE TAKEN WHICH WOULD ALLOW AN OFFERING OF THE SHARES TO THE
PUBLIC IN FINLAND. THE SECURITIES MUST NOT BE DIRECTLY OR INDIRECTLY OFFERED,
DISTRIBUTED OR SOLD IN FINLAND EXCEPT IN COMPLIANCE WITH ALL APPLICABLE
PROVISIONS OF THE LAWS OF FINLAND, INCLUDING THE FINNISH SECURITIES MARKET ACT
(26.5.1989/495) AND THE REGULATIONS ISSUED THEREUNDER, AS AMENDED.
FOR PURCHASERS IN FRANCE ONLY: THIS OFFERING CIRCULAR HAS NOT BEEN AND
WILL NOT BE CERTIFIED BY THE FRENCH AUTORITE DES MARCHES FINANCIERS ("AMF")
(FORMERLY THE COMMISSION DES OPERATIONS DE BOURSE ("COB")). THE SECURITIES
OFFERING HAS NOT AND WILL NOT BE APPROVED BY THE AMF, AND THE TRANSACTION WILL
NOT BE ADVERTISED IN FRANCE. ANY PERSON WHO IS IN POSSESSION OF THIS OFFERING
CIRCULAR UNDERSTANDS THAT NO ACTION HAS BEEN OR WILL BE TAKEN WHICH WOULD ALLOW
AN OFFERING OF THE SHARES TO THE PUBLIC IN FRANCE. ACCORDINGLY, THE SHARES MAY
NOT BE OFFERED, SOLD OR DELIVERED AND NEITHER THIS OFFERING CIRCULAR NOR ANY
OTHER OFFERING MATERIALS RELATING TO THESE SECURITIES MAY BE DISTRIBUTED OR MADE
AVAILABLE TO THE PUBLIC IN FRANCE. THE TRANSFER TO THE PUBLIC, EITHER DIRECTLY
OR INDIRECTLY, OF THE SECURITIES PURCHASED MUST COMPLY WITH FRENCH PUBLIC
OFFERING REGULATIONS PURSUANT TO ARTICLES L. 411-1, L. 411-2 AND L. 412-1 OF THE
FRENCH MONETARY AND FINANCIAL CODE (THE "MF CODE"). PURCHASERS OF THE SECURITIES
MAY TAKE PART IN THE TRANSACTION ONLY FOR THEIR OWN ACCOUNT. INDIVIDUAL SALES OF
THESE SECURITIES IN FRANCE MAY ONLY BE MADE EITHER TO QUALIFIED INVESTORS IN
FRANCE AS DEFINED IN ARTICLE L. 411-2 OF THE MF CODE OR TO A RESTRICTED CIRCLE
OF INVESTORS AS DEFINED IN ARTICLE L. 411-2 OF THE MF CODE. WHEN SALES OF
SECURITIES ARE MADE TO A RESTRICTED CIRCLE OF INVESTORS AS DEFINED IN ARTICLE L.
411-2 OF THE MF CODE WHICH IS NOT LESS THAN 100 INDIVIDUALS, EACH OF THESE
INDIVIDUALS MUST PROVIDE CERTIFICATION AS TO THEIR PERSONAL ASSOCIATION, OF A
PROFESSIONAL OR FAMILY NATURE, WITH A MEMBER OF THE MANAGEMENT
v
OF THE COMPANY. FURTHERMORE, FOLLOWING ARTICLE L. 423-1 OF THE MF CODE WITH
REGARD TO SOLICITATION AND ARTICLE L. 341-10 OF THE MF CODE WITH REGARD TO
CANVASSING, NO SOLICITATION OR CANVASSING OF THE PUBLIC WILL BE CONDUCTED IN
CONNECTION WITH THE SECURITIES OFFERING.
FOR PURCHASERS IN GERMANY ONLY: ANY PERSON WHO IS IN POSSESSION OF THIS
OFFERING CIRCULAR UNDERSTANDS THAT NO ACTION HAS BEEN OR WILL BE TAKEN WHICH
WOULD ALLOW AN OFFERING OF THE SHARES TO THE PUBLIC IN GERMANY. ACCORDINGLY,
THIS OFFERING CIRCULAR DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION
OF AN OFFER TO BUY, THE SHARES TO THE PUBLIC IN GERMANY. THEREFORE, THE SHARES
MAY NOT BE OFFERED, SOLD, OR DELIVERED AND NEITHER THIS OFFERING CIRCULAR NOR
ANY OTHER OFFERING MATERIALS RELATING TO THE SHARES MAY BE DISTRIBUTED OR MADE
AVAILABLE TO THE PUBLIC IN GERMANY OR BE USED FOR, OR IN CONNECTION WITH, AN
OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, THE SHARES TO THE PUBLIC IN
GERMANY. INDIVIDUAL SALES OF THE SHARES TO ANY PERSON IN GERMANY MAY ONLY BE
MADE TO (I) CERTAIN PERSONS WHO ON A PROFESSIONAL OR COMMERCIAL BASIS (AS
DEFINED IN sec. 2 PARA. 1 GERMAN SALES PROSPECTUS ACT) PURCHASE OR SELL
SECURITIES FOR THEIR OWN ACCOUNT OR FOR THE ACCOUNT OF THIRD PARTIES, OR (II) A
LIMITED GROUP OF PERSONS (AS DEFINED IN sec. 2 PARA. 2 GERMAN SALES PROSPECTUS
ACT), AND ACCORDING TO ANY OTHER GERMAN SECURITIES, PROSPECTUS, TAX AND OTHER
APPLICABLE LAWS AND REGULATIONS.
FOR PURCHASERS IN GUERNSEY ONLY: THE SHARES MAY ONLY BE OFFERED OR SOLD IN
OR FROM WITHIN THE BAILIWICK OF GUERNSEY EITHER (I) BY PERSONS LICENSED TO DO SO
UNDER THE PROTECTION OF INVESTORS (BAILIWICK OF GUERNSEY) LAW, 1987 (AS AMENDED)
(THE "POI LAW"); OR (II) TO PERSONS LICENSED UNDER THE POI LAW; OR (III) TO
PERSONS LICENSED UNDER THE INSURANCE BUSINESS (BAILIWICK OF GUERNSEY) LAW, 2002,
THE BANKING SUPERVISION (BAILIWICK OF GUERNSEY) LAW, 1994, OR THE REGULATION OF
FIDUCIARIES, ADMINISTRATION BUSINESSES AND COMPANY DIRECTORS, ETC, (BAILIWICK OF
GUERNSEY) LAW, 2000.
CONSENT UNDER THE CONTROL OF BORROWING (BAILIWICK OF GUERNSEY) ORDINANCES
1959 - 2003 HAS NOT BEEN OBTAINED TO THE CIRCULATION OF THIS OFFERING CIRCULAR
IN THE BAILIWICK OF GUERNSEY. ACCORDINGLY, NO OFFER OF THE SHARES THAT IS A
PUBLIC OFFER, AN OFFER TO EXISTING HOLDERS OF SECURITIES OF THE COMPANY, OR AN
OFFER TO EXISTING HOLDERS OF SECURITIES OF ANY BODY CORPORATE SPECIFIED IN THIS
OFFER, MAY BE CIRCULATED IN THE BAILIWICK OF GUERNSEY. THE DIRECTORS OF THE
COMPANY MAY, BUT ARE NOT OBLIGED TO, APPLY FOR SUCH CONSENT IN THE FUTURE.
FOR PURCHASERS IN ICELAND ONLY: THIS OFFERING CIRCULAR HAS NOT BEEN AND
WILL NOT BE REGISTERED WITH THE ICELANDIC FINANCIAL SUPERVISORY AUTHORITY
("FME"). THE SECURITIES OFFERING HAS NOT BEEN AND WILL NOT BE APPROVED BY THE
FME, AND THE TRANSACTION WILL NOT BE ADVERTISED IN ICELAND. ANY PERSON WHO IS IN
POSSESSION OF THIS OFFERING CIRCULAR UNDERSTANDS THAT NO ACTION HAS BEEN OR WILL
BE TAKEN WHICH WOULD ALLOW AN OFFERING OF THE SHARES TO THE PUBLIC IN ICELAND.
ACCORDINGLY, THE SHARES MAY NOT BE OFFERED, SOLD OR DELIVERED AND NEITHER THIS
OFFERING CIRCULAR NOR ANY OTHER OFFERING MATERIALS RELATING TO THESE SECURITIES
MAY BE DISTRIBUTED OR MADE AVAILABLE TO THE PUBLIC IN ICELAND.
FOR PURCHASERS IN THE REPUBLIC OF IRELAND ONLY: THIS OFFERING CIRCULAR HAS
NOT BEEN AND WILL NOT BE REGISTERED WITH ANY REGULATORY OR OTHER AUTHORITIES
vi
IN IRELAND. ANY PERSON WHO IS IN POSSESSION OF THIS OFFERING CIRCULAR
UNDERSTANDS THAT NO ACTION HAS BEEN OR WILL BE TAKEN WHICH WOULD ALLOW AN
OFFERING OF THE SHARES TO THE PUBLIC IN IRELAND. ACCORDINGLY, THE SHARES MAY NOT
BE OFFERED, SOLD OR DELIVERED AND NEITHER THIS OFFERING CIRCULAR NOR ANY OTHER
OFFERING MATERIALS RELATING TO THESE SECURITIES MAY BE DISTRIBUTED OR MADE
AVAILABLE TO THE PUBLIC IN IRELAND. INDIVIDUAL SALES OF THESE SECURITIES TO ANY
PERSON IN IRELAND MAY ONLY BE MADE TO LESS THAN TWENTY (20) PERSONS, WHETHER
INSTITUTIONS OR INDIVIDUALS, AND WHETHER ON A SOLICITED OR UNSOLICITED BASIS.
FOR PURCHASERS IN THE STATE OF ISRAEL ONLY: NEITHER THE OFFERING
CONTEMPLATED BY THIS OFFERING CIRCULAR NOR THE SECURITIES OFFERED THEREUNDER
HAVE BEEN OR WILL BE REGISTERED WITH THE SECURITIES COMMISSION OF THE STATE OF
ISRAEL. ACCORDINGLY, THE SECURITIES OFFERED BY THIS OFFERING CIRCULAR MAY NOT BE
OFFERED OR SOLD TO THE GENERAL PUBLIC IN THE STATE OF ISRAEL. THE SECURITIES
OFFERED BY THIS OFFERING CIRCULAR SHALL ONLY BE OFFERED TO, AND MAY ONLY BE
ACQUIRED BY, THOSE PARTIES THAT ARE "ACCREDITED INVESTORS" AS DEFINED IN SECTION
15 OF THE SECURITIES LAW, 5728-1968, OF THE STATE OF ISRAEL AND THE RULES AND
REGULATIONS ADOPTED THEREUNDER.
FOR PURCHASERS IN THE REPUBLIC OF ITALY ONLY: THIS OFFERING CIRCULAR HAS
NOT BEEN SUBMITTED TO THE CLEARANCE PROCEDURES OF COMMISSIONE NAZIONALE PER LE
SOCIETA E LA BORSA ("CONSOB") AND HAVE NOT BEEN AND WILL NOT BE SUBJECT TO THE
FORMAL REVIEW OR CLEARANCE PROCEDURES OF CONSOB AND ACCORDINGLY MAY NOT BE USED
IN CONNECTION WITH ANY OFFERING OF SHARES OF COMMON STOCK IN THE REPUBLIC OF
ITALY ("ITALY") OTHER THAN TO "PROFESSIONAL INVESTORS" (AS DEFINED BELOW AND IN
ACCORDANCE WITH APPLICABLE ITALIAN SECURITIES LAWS AND REGULATIONS). ANY OFFER
OF SHARES OF COMMON STOCK IN ITALY IN RELATION TO THE OFFERING IS BEING MADE
ONLY TO PROFESSIONAL INVESTORS (EACH A "PROFESSIONAL INVESTOR") PURSUANT TO
ARTICLE 30, PARAGRAPH 2 AND ARTICLE 100 A OF LEGISLATIVE DECREE NO. 58 OF 24
FEBRUARY 1998, AS AMENDED ("DECREE NO. 58"), AND AS DEFINED IN ARTICLES 25 AND
31, PARAGRAPH 2 OF CONSOB REGULATION NO. 11522 OF 1 JULY 1998, AS AMENDED
("REGULATION NO. 11522"), AND EXCLUDING INDIVIDUALS AS DEFINED PURSUANT TO THE
AFOREMENTIONED ARTICLE 31, PARAGRAPH 2 WHO MEET THE REQUIREMENTS IN ORDER TO
EXERCISE ADMINISTRATIVE, MANAGERIAL OR SUPERVISORY FUNCTIONS AT A REGISTERED
SECURITIES DEALING FIRM (A SOCIETA DI INTERMEDIAZIONE MOBILIARE, OR "SIM"),
MANAGEMENT COMPANIES AUTHORIZED TO MANAGE INDIVIDUAL PORTFOLIOS ON BEHALF OF
THIRD PARTIES (SOCIETA DI GESTIONE DEL RISPARMIO, OR "SGR") AND FIDUCIARY
COMPANIES (SOCIETA FIDUCIARIE) MANAGING PORTFOLIO INVESTMENTS REGULATED BY
ARTICLE 60, PARAGRAPH 4 OF LEGISLATIVE DECREE NO. 415 OF 23 JULY 1996 AND
OTHERWISE IN ACCORDANCE WITH APPLICABLE ITALIAN LAWS AND REGULATIONS PROVIDED
THEREIN. UNDER NO CIRCUMSTANCES SHOULD THIS OFFERING CIRCULAR BE CIRCULATED
AMONG, OR BE DISTRIBUTED IN ITALY TO, ANY MEMBER OF THE GENERAL PUBLIC IN ITALY
OR TO INDIVIDUALS OR ENTITIES FALLING OUTSIDE THE CATEGORIES OF PROFESSIONAL
INVESTORS. ANY SUCH OFFER OR ISSUE OR ANY DISTRIBUTION OF THIS OFFERING CIRCULAR
WITHIN ITALY AND/OR THE RENDERING OF ADVICE OF ANY NATURE WHATSOEVER IN
CONNECTION WITH THE OFFERING MUST BE CONDUCTED EITHER BY BANKS, INVESTMENT FIRMS
(AS DEFINED IN DECREE NO. 58) AND FINANCIAL COMPANIES ENROLLED IN THE SPECIAL
REGISTER PROVIDED FOR BY ARTICLE 107 OF LEGISLATIVE DECREE NO. 385 OF 1
SEPTEMBER 1993, AS AMENDED, TO THE EXTENT DULY AUTHORIZED TO ENGAGE
vii
IN THE PLACEMENT AND/OR UNDERWRITING OF FINANCIAL INSTRUMENTS IN ITALY IN
ACCORDANCE WITH THE RELEVANT PROVISIONS OF DECREE NO. 58.
FOR PURCHASERS IN JERSEY ONLY: CONSENT UNDER THE CONTROL OF BORROWING
(JERSEY) ORDER 1958 (THE "COB ORDER") HAS NOT BEEN OBTAINED FOR THE CIRCULATION
OF THIS OFFERING CIRCULAR. ACCORDINGLY, THE OFFER THAT IS THE SUBJECT OF THIS
OFFERING CIRCULAR MAY ONLY BE MADE IN JERSEY WHERE SUCH OFFER IS NOT AN OFFER TO
THE PUBLIC (AS DEFINED IN THE COB ORDER) OR WHERE (IN THE ABSENCE OF A RELEVANT
CONNECTION WITH JERSEY) THE OFFER IS VALID (AS DEFINED IN THE COB ORDER) IN THE
UNITED KINGDOM AND IS CIRCULATED IN JERSEY ONLY TO PERSONS SIMILAR TO THOSE TO
WHOM, AND IN A MANNER SIMILAR TO THAT IN WHICH, IT IS FOR THE TIME BEING
CIRCULATED IN THE UNITED KINGDOM. THE DIRECTORS OF THE COMPANY MAY, BUT ARE NOT
OBLIGED TO, APPLY FOR SUCH CONSENT IN THE FUTURE. INVESTMENT BUSINESS CARRIED
OUT IN OR FROM WITHIN JERSEY, INCLUDING BUT NOT LIMITED TO THE SALE OR ADVICE IN
RELATION TO INVESTMENTS, IS REGULATED UNDER THE FINANCIAL SERVICES (JERSEY) LAW
1998.
FOR INDIVIDUAL PURCHASERS IN LUXEMBOURG ONLY: THIS OFFERING CIRCULAR HAS
NOT BEEN AND WILL NOT BE REGISTERED WITH THE COMMISSION FOR THE SUPERVISION OF
THE FINANCIAL SECTOR ("CSSF"). THE SECURITIES HAVE NOT BEEN AND WILL NOT BE
AUTHORIZED FOR PUBLIC OFFERING IN LUXEMBOURG AND MAY NOT BE OFFERED OR SOLD IN
LUXEMBOURG IN CIRCUMSTANCES THAT WOULD CONSTITUTE A PUBLIC OFFER UNLESS THE
REQUIREMENTS OF LUXEMBOURG LAW CONCERNING PUBLIC OFFERS HAVE BEEN COMPLIED WITH.
THIS OFFERING CIRCULAR MAY NOT BE DUPLICATED. IN ADDITION, THEY MAY NOT BE
PASSED TO ANOTHER PERSON.
FOR INSTITUTIONAL INVESTORS IN LUXEMBOURG ONLY: THIS OFFERING CIRCULAR HAS
NOT BEEN AND WILL NOT BE REGISTERED WITH THE COMMISSION FOR THE SUPERVISION OF
THE FINANCIAL SECTOR ("CSSF"). THE SECURITIES HAVE NOT BEEN AND WILL NOT BE
AUTHORIZED FOR PUBLIC OFFERING IN LUXEMBOURG AND MAY NOT BE OFFERED OR SOLD IN
LUXEMBOURG IN CIRCUMSTANCES THAT WOULD CONSTITUTE A PUBLIC OFFER UNLESS THE
REQUIREMENTS OF LUXEMBOURG LAW CONCERNING PUBLIC OFFERS HAVE BEEN COMPLIED WITH.
FOR PURCHASERS IN MONACO ONLY: THIS OFFERING CIRCULAR HAS NOT BEEN AND
WILL NOT BE REGISTERED WITH OR APPROVED BY THE REGULATORY AUTHORITIES IN MONACO.
THIS OFFERING CIRCULAR IS PERSONAL TO THE RECIPIENT AND HAVE BEEN PREPARED
SOLELY FOR USE IN CONNECTION WITH THE OFFERING DESCRIBED HEREIN. DISTRIBUTION OF
THIS OFFERING CIRCULAR TO ANY PERSON OTHER THAN THE RECIPIENT AND THOSE PERSONS,
IF ANY, RETAINED TO ADVISE SUCH RECIPIENT WITH RESPECT TO THE OFFER AND SALE OF
THE SECURITIES IS UNAUTHORIZED, AND ANY DISCLOSURE OF ANY OF THEIR CONTENTS IS
PROHIBITED. EACH RECIPIENT, BY ACCEPTING DELIVERY OF THIS OFFERING CIRCULAR,
AGREES TO THE FOREGOING AND AGREES TO MAKE NO COPIES OF THIS OFFERING CIRCULAR.
THIS OFFERING CIRCULAR DOES NOT CONSTITUTE AN OFFER TO SELL, OR ANY SOLICITATION
OF AN OFFER TO BUY, ANY OF THE SHARES OFFERED HEREBY BY ANY PERSON IN ANY
JURISDICTION IN WHICH IT IS UNLAWFUL FOR SUCH PERSON TO MAKE SUCH AN OFFERING OR
SOLICITATION. NEITHER THE DELIVERY OF THIS OFFERING CIRCULAR NOR ANY SALE MADE
HEREUNDER OF THE SHARES DESCRIBED HEREIN SHALL UNDER ANY CIRCUMSTANCES IMPLY
THAT THE INFORMATION HEREIN IS CORRECT AS OF ANY DATE SUBSEQUENT TO THE DATE
HEREOF. IF THE RECIPIENT DOES NOT PURCHASE ANY SHARES, OR THIS OFFERING IS
TERMINATED, THE RECIPIENT AGREES TO RETURN THIS OFFERING CIRCULAR AND ALL
DOCUMENTS
viii
DELIVERED CONCERNING THEM TO THE UNDERWRITERS OR THEIR REPRESENTATIVE WHO
PROVIDED THE SAME.
FOR PURCHASERS IN THE NETHERLANDS ONLY: THE COMPANY'S SHARES OF COMMON
STOCK MAY NOT BE OFFERED, SOLD, TRANSFERRED OR DELIVERED IN OR FROM THE
NETHERLANDS AS PART OF THEIR INITIAL DISTRIBUTION OR AT ANY TIME THEREAFTER,
DIRECTLY OR INDIRECTLY, OTHER THAN TO INDIVIDUALS OR LEGAL ENTITIES, WHICH
INCLUDE, BUT ARE NOT LIMITED TO, BANKS, BROKERS, DEALERS, INSTITUTIONAL
INVESTORS AND UNDERTAKINGS WITH A TREASURY DEPARTMENT, WHO OR WHICH TRADE OR
INVEST IN SECURITIES IN THE CONDUCT OF A BUSINESS OR A PROFESSION.
FOR PURCHASERS IN NORWAY ONLY: THIS OFFERING CIRCULAR HAS NOT BEEN FILED
WITH THE NORWEGIAN COMPANY REGISTRY OR WITH THE OSLO STOCK EXCHANGE IN
ACCORDANCE WITH THE NORWEGIAN SECURITIES TRADING ACT, CHAPTER 5, AND THEREFORE
MAY NOT BE DISTRIBUTED TO MORE THAN FIFTY (50) POTENTIAL INVESTORS IN NORWAY.
FOR PURCHASERS IN SAUDI ARABIA ONLY: THIS OFFERING CIRCULAR HAVE NOT BEEN
AND WILL NOT BE REGISTERED WITH THE SAUDI ARABIAN MONETARY AGENCY ("SAMA"). THE
SECURITIES OFFERING HAS NOT BEEN AND WILL NOT BE APPROVED BY SAMA, AND THE
TRANSACTION WILL NOT BE ADVERTISED IN SAUDI ARABIA. ANY PERSON WHO IS IN
POSSESSION OF THIS OFFERING CIRCULAR UNDERSTANDS THAT NO ACTION HAS BEEN OR WILL
BE TAKEN WHICH WOULD ALLOW AN OFFERING OF THE SHARES TO THE PUBLIC IN SAUDI
ARABIA. ACCORDINGLY, THE SHARES MAY NOT BE OFFERED, SOLD OR DELIVERED AND
NEITHER THIS OFFERING CIRCULAR NOR ANY OTHER OFFERING MATERIALS RELATING TO
THESE SECURITIES MAY BE DISTRIBUTED OR MADE AVAILABLE TO THE PUBLIC IN SAUDI
ARABIA. THE OFFERING IS MADE WITHOUT THE APPROVAL, UNDER ARTICLE 228 OF THE
REGULATIONS FOR COMPANIES, ROYAL DECREE NO. M/6 DATED 22/3/1385 H. (20 JULY 1965
G.), AS AMENDED, OF THE MINISTRY OF COMMERCE.
FOR PURCHASERS IN SPAIN ONLY: THIS OFFERING CIRCULAR HAS NOT BEEN AND WILL
NOT BE REGISTERED BY THE SPANISH SECURITIES EXCHANGE COMMISSION ("COMISION
NACIONAL DEL MERCADO DE VALORES"). THE SECURITIES MUST NOT BE OFFERED,
DISTRIBUTED OR SOLD IN SPAIN EXCEPT IN COMPLIANCE WITH THE REQUIREMENTS OF THE
FOLLOWING SPANISH REGULATIONS, AS AMENDED FROM TIME TO TIME: THE SPANISH
SECURITIES MARKET ACT OF 28TH JULY, 1988; AND ROYAL DECREE 291/1992, OF 27TH
MARCH 1992, ON ISSUANCE AND PUBLIC SALE OFFERINGS OF SECURITIES.
FOR PURCHASERS IN SWEDEN ONLY: THIS OFFERING CIRCULAR HAS NOT BEEN AND
WILL NOT BE APPROVED BY OR REGISTERED WITH THE SWEDISH FINANCIAL SUPERVISORY
AUTHORITY ("SFSA"). THE SECURITIES OFFERING HAS NOT BEEN AND WILL NOT BE
APPROVED BY THE SFSA, AND THE TRANSACTION WILL NOT BE ADVERTISED IN SWEDEN. ANY
PERSON WHO IS IN POSSESSION OF THIS OFFERING CIRCULAR UNDERSTANDS THAT NO ACTION
HAS BEEN OR WILL BE TAKEN WHICH WOULD ALLOW AN OFFERING OF THE SHARES TO THE
PUBLIC IN SWEDEN. ACCORDINGLY, NEITHER THIS OFFERING CIRCULAR NOR ANY OTHER
OFFERING MATERIALS RELATING TO THE SECURITIES MAY BE DISTRIBUTED OR MADE
AVAILABLE TO THE PUBLIC IN SWEDEN.
FOR PURCHASERS IN SWITZERLAND ONLY: THE COMPANY HAS NOT BEEN AUTHORIZED BY
THE SWISS FEDERAL BANKING COMMISSION AS A FOREIGN INVESTMENT FUND; NOR DOES THIS
OFFERING CIRCULAR CONSTITUTE AN ISSUE PROSPECTUS FOR THE OFFERING OF NEW SHARES
IN ACCORDANCE WITH APPLICABLE SWISS LEGISLA-
ix
TION. ACCORDINGLY, COMMON SHARES MAY NOT BE OFFERED TO THE PUBLIC IN OR FROM
SWITZERLAND. THIS OFFERING CIRCULAR MAY ONLY BE USED BY THOSE PERSONS TO WHOM
THEY HAVE BEEN HANDED OUT IN CONNECTION WITH THE OFFER DESCRIBED THEREIN. THEY
MAY NOT BE USED IN CONNECTION WITH ANY OTHER OFFER AND SHALL IN PARTICULAR NOT
BE DISTRIBUTED TO THE PUBLIC IN SWITZERLAND.
FOR INSTITUTIONAL INVESTORS IN THE UNITED KINGDOM ONLY: THE COMPANY HAS
NOT PREPARED OR FILED AND WILL NOT PREPARE OR FILE IN THE UNITED KINGDOM
PURSUANT TO THE PUBLIC OFFERS OF SECURITIES REGULATIONS 1995 ("POS") A
PROSPECTUS REGARDING THE SECURITIES OFFERED. ACCORDINGLY, THE SECURITIES MAY NOT
BE OFFERED TO PERSONS IN THE UNITED KINGDOM EXCEPT TO PERSONS WHOSE ORDINARY
ACTIVITIES INVOLVE THEM IN ACQUIRING, HOLDING, MANAGING OR DISPOSING OF
INVESTMENTS (AS PRINCIPAL OR AGENT) FOR THE PURPOSES OF THEIR BUSINESSES, OR
OTHERWISE IN CIRCUMSTANCES THAT WILL NOT CONSTITUTE OR RESULT IN AN OFFER TO THE
PUBLIC IN THE UNITED KINGDOM WITHIN THE MEANING OF THE POS.
THIS OFFERING CIRCULAR HAS NOT BEEN APPROVED FOR THE PURPOSES OF SECTION 21
OF THE FINANCIAL SERVICES AND MARKETS ACT 2000 AND ACCORDINGLY MAY ONLY BE
ISSUED OR PASSED ON IN THE UNITED KINGDOM IN ACCORDANCE WITH THE FINANCIAL
SERVICES AND MARKETS ACT 2000 (FINANCIAL PROMOTION) ORDER 2001 (THE "ORDER")
INCLUDING TO "INVESTMENT PROFESSIONALS" AS DEFINED IN THE ORDER OR TO PERSONS TO
WHOM THEY MAY OTHERWISE LAWFULLY BE ISSUED OR PASSED ON. THIS OFFERING CIRCULAR
SHOULD NOT BE RELIED UPON BY ANY OTHER PERSON.
FOR SOPHISTICATED INVESTORS IN THE UNITED KINGDOM ONLY: THERE ARE
RESTRICTIONS ON THE OFFER AND SALE OF SECURITIES IN THE UNITED KINGDOM. ALL
APPLICABLE PROVISIONS OF THE FINANCIAL SERVICES AND MARKETS ACT 2000 ("FSMA")
AND THE PUBLIC OFFERS OF SECURITIES REGULATIONS 1995 ("POS") MUST BE COMPLIED
WITH. YOUR ATTENTION IS SPECIFICALLY DRAWN TO THE FOLLOWING MATTERS WHICH APPLY
TO THIS OFFERING CIRCULAR.
THE COMPANY HAS NOT PREPARED OR FILED AND WILL NOT PREPARE OR FILE IN THE
UNITED KINGDOM PURSUANT TO THE POS A PROSPECTUS REGARDING THE SECURITIES
OFFERED. ACCORDINGLY, THE SECURITIES MAY NOT BE OFFERED TO PERSONS IN THE UNITED
KINGDOM EXCEPT TO PERSONS WHOSE ORDINARY ACTIVITIES INVOLVE THEM IN ACQUIRING,
HOLDING, MANAGING OR DISPOSING OF INVESTMENTS (AS PRINCIPAL OR AGENT) FOR THE
PURPOSES OF THEIR BUSINESSES, OR OTHERWISE IN CIRCUMSTANCES THAT WILL NOT
CONSTITUTE OR RESULT IN AN OFFER TO THE PUBLIC IN THE UNITED KINGDOM WITHIN THE
MEANING OF THE POS.
SECTION 21 OF THE FSMA WOULD REQUIRE THIS OFFERING CIRCULAR TO BE APPROVED
BY AN AUTHORIZED PERSON UNLESS AN EXEMPTION IS AVAILABLE UNDER THE FINANCIAL
SERVICES AND MARKETS ACT 2000 (FINANCIAL PROMOTIONS) ORDER 2001 (THE "ORDER").
THIS OFFERING CIRCULAR HAS NOT BEEN APPROVED BY AN AUTHORIZED PERSON AND ARE
EXEMPT FROM THE GENERAL RESTRICTIONS IN SECTION 21 OF THE FSMA ON THE GROUNDS
THAT THEY ARE BEING MADE AVAILABLE TO A CERTIFIED SOPHISTICATED INVESTOR WITHIN
THE
x
MEANING OF ARTICLE 50 OF THE ORDER. IN ORDER TO QUALIFY AS A CERTIFIED
SOPHISTICATED INVESTOR, AN INDIVIDUAL MUST HAVE:
(A) A CURRENT CERTIFICATE SIGNED BY AN AUTHORIZED PERSON TO THE EFFECT THAT
THE INDIVIDUAL IS CURRENTLY KNOWLEDGEABLE TO UNDERSTAND THE RISKS
ASSOCIATED WITH THE SECURITIES BEING OFFERED; AND
(B) MADE A STATEMENT SIGNED BY THE INDIVIDUAL DATED WITHIN THE PERIOD OF 12
MONTHS PRIOR TO THE ISSUE OF THIS OFFERING CIRCULAR CONFIRMING THE
INDIVIDUAL'S QUALIFICATION FOR EXEMPTION AS A SOPHISTICATED INVESTOR
AND THE INDIVIDUAL'S UNDERSTANDING THAT THE INDIVIDUAL MAY THEREFORE
RECEIVE COMMUNICATIONS WHICH HAVE NOT BEEN APPROVED BY AN AUTHORIZED
PERSON AND THAT SUCH COMMUNICATIONS WILL NOT BE SUBJECT TO THE CONTROLS
WHICH WOULD OTHERWISE APPLY,
IN EACH CASE IN ACCORDANCE WITH THE PROVISIONS OF ARTICLE 50 OF THE ORDER,
TOGETHER REFERRED TO AS A "CERTIFICATION". BY ACCEPTING AND ACTING UPON THIS
OFFERING CIRCULAR, YOU ARE DEEMED TO WARRANT AND UNDERTAKE THAT:
(A) YOU FALL WITHIN THE SOPHISTICATED INVESTOR EXEMPTION CONTAINED IN THE
ORDER, AS DESCRIBED ABOVE; AND
(B) YOU WILL COMPLY WITH ALL APPLICABLE PROVISIONS OF THE FSMA AND THE
ORDER WITH RESPECT TO ANYTHING YOU DO IN RELATION TO THIS OFFERING
CIRCULAR.
COMPLETION OF THE PURCHASE OF ANY SECURITIES PURSUANT TO THIS OFFERING
CIRCULAR IS CONDITIONAL IN ALL RESPECTS UPON RECEIPT BY US OF YOUR CURRENT
CERTIFICATION. YOU SHOULD NOTE THAT RELIANCE ON THIS OFFERING CIRCULAR FOR THE
PURPOSE OF ENGAGING IN ANY INVESTMENT ACTIVITY MAY EXPOSE YOU TO A SIGNIFICANT
RISK OF LOSING ALL OF THE PROPERTY YOU HAVE INVESTED OR INCURRING ADDITIONAL
LIABILITY. IF YOU ARE IN ANY DOUBT ABOUT THE INVESTMENT TO WHICH THIS OFFERING
CIRCULAR RELATES, YOU SHOULD CONSULT AN AUTHORIZED PERSON SPECIALIZING IN
INVESTMENTS OF THIS KIND. IN ADDITION, IF YOU ARE IN ANY DOUBT AS TO THE
REQUIREMENTS OF ARTICLE 50 IN THE CONTEXT OF THIS OFFERING CIRCULAR, YOU SHOULD
CONSULT YOUR OWN PROFESSIONAL ADVISER.
THIS OFFERING CIRCULAR IS INTENDED FOR USE BY THE ADDRESSEE ONLY AND ARE
NOT FOR CIRCULATION AND DISSEMINATION TO THIRD PARTIES. RECIPIENTS OTHER THAN
THE PERSON TO WHOM THIS OFFERING CIRCULAR IS ADDRESSED SHALL NOT BE PERMITTED TO
ENGAGE IN THE INVESTMENT ACTIVITY TO WHICH THIS OFFERING CIRCULAR RELATES.
---------------------
We have filed for registration in the U.S. Patent and Trademark Office for
the marks "Luminent Mortgage Capital, Inc." and "Luminent." All other brand
names or trademarks appearing in this prospectus are the property of their
respective holders.
xi
SUMMARY
This summary highlights the material information contained elsewhere in
this prospectus. You should read this entire prospectus carefully, including the
section titled "Risk Factors" and our financial statements and the notes thereto
before making an investment in our common stock. As used in this prospectus,
"Luminent," "company," "we," "our," and "us" refer to Luminent Mortgage Capital,
Inc., except where the context otherwise requires. Unless otherwise indicated,
the information in this prospectus assumes that the underwriters will not
exercise their over-allotment option to purchase additional shares of our common
stock.
LUMINENT MORTGAGE CAPITAL, INC.
We were incorporated in April 2003 to invest primarily in U.S. agency and
other highly-rated, single-family, adjustable-rate, hybrid adjustable-rate and
fixed-rate mortgage-backed securities, which we acquire in the secondary market.
Our strategy is to acquire mortgage-related assets, finance these purchases in
the capital markets and use leverage in order to provide an attractive return on
stockholders' equity. Through this strategy, we seek to earn income, which is
generated from the spread between the yield on our earning assets and our costs,
including the interest cost of the funds we borrow.
We commenced operations in June 2003, following the completion of a private
placement of our common stock, in which we raised net proceeds of approximately
$159.7 million. On December 18, 2003, we completed our initial public offering,
or IPO, of our common stock in which we raised net proceeds of approximately
$157.0 million. Our common stock began trading on the NYSE under the trading
symbol "LUM" on December 19, 2003. We received the net proceeds from our IPO in
late December. As of December 31, 2003, we had invested substantially all of the
net proceeds from that offering, plus approximately $1.7 billion of borrowed
funds, for a total of $2.2 billion of U.S. agency and other highly-rated,
residential mortgage-backed securities. However, at December 31, 2003, we had
not fully levered our portfolio to within our target range of eight to 12 times
the amount of our equity. As a result, the total amount of mortgage-backed
securities and repurchase agreement liabilities as of December 31, 2003 were
lower than if we had fully levered our portfolio through additional repurchase
agreement liabilities and related mortgage-backed security purchases.
We invest primarily in adjustable-rate and hybrid adjustable-rate
mortgage-backed securities. Adjustable-rate mortgage-backed securities have
interest rates that reset periodically, typically every six months or on an
annual basis. Hybrid adjustable-rate mortgage-backed securities have interest
rates that are fixed for the first few years of the loan -- typically three,
five, seven or 10 years -- and thereafter reset periodically in a manner similar
to adjustable-rate mortgage-backed securities. As of December 31, 2003,
approximately 8.6% of our investment portfolio was comprised of adjustable-rate
mortgage-backed securities and approximately 88.9% was comprised of hybrid
adjustable-rate mortgage-backed securities. In addition, as of December 31,
2003, 63% of the mortgage-backed securities in our investment portfolio were
guaranteed by Fannie Mae, Freddie Mac or the Government National Mortgage
Administration, or Ginnie Mae, and the remaining 37% had AAA credit ratings from
at least one nationally-recognized statistical rating agency.
With the net proceeds of this offering and other borrowed funds, we intend
to invest in mortgage-backed securities similar to those currently in our
portfolio. We will seek to acquire mortgage-backed securities that will produce
competitive returns, taking into consideration the amount and nature of the
anticipated returns from the investment, our ability to pledge the investment
for secured, collateralized borrowings and the costs associated with financing,
managing, securitizing and reserving for these investments. As of the date of
this prospectus, we have not identified any specific mortgage-backed securities
that we intend to acquire with the net proceeds of this offering. All of the
mortgage-backed securities that we acquired with the net proceeds of our recent
IPO are agency-backed or have AAA credit ratings from at least one
nationally-recognized statistical rating agency, and all of the securities are
either adjustable-rate or hybrid adjustable-rate mortgage-backed securities. We
expect that the substantial majority, or perhaps the entirety of the
mortgage-backed securities that we acquire with the net proceeds
1
of this offering will be agency-backed or have AAA credit ratings. Such
securities are readily available in the market. As of December 31, 2003, the
market for residential mortgage debt that had been securitized into
mortgage-backed securities was approximately $4.2 trillion, approximately $3.4
trillion of which was agency-backed and, therefore, generally consistent with
our investment guidelines. As of December 31, 2003, approximately $51.3 billion
of all available mortgage-backed securities were held by REITs.
We have financed our acquisition of mortgage-related assets by investing
our equity and by borrowing at short-term rates under repurchase agreements. We
intend to continue to finance our acquisitions in this manner. We generally seek
to borrow between eight and 12 times the amount of our equity. We actively
manage the adjustment periods and the selection of the interest rate indices of
our borrowings against the adjustment periods and the selection of indices on
our mortgage-related assets in order to manage our liquidity and interest
rate-related risks. We may also choose to engage in various hedging activities
designed to match more closely the terms of our assets and liabilities. As of
March 29, 2004, we were party to hedging arrangements as described in "-- Recent
Developments" below.
As a long-term holder of mortgage-backed securities, we are focused on
acquiring, financing and managing a diverse portfolio of mortgage-backed
securities with a variety of characteristics that we believe will provide
attractive returns in a multitude of interest rate and prepayment environments.
We do not construct our overall investment portfolio in order to express a
directional expectation for interest rates or mortgage prepayment rates.
We review the credit risk associated with each potential investment and may
diversify our portfolio to avoid undue geographic, insurer, industry and other
types of concentrations. By maintaining a large percentage of our assets in high
quality and highly-rated assets, many of which are guaranteed under limited
circumstances as to payment of a limited amount of principal and interest by
federal agencies or federally chartered entities such as Fannie Mae, Freddie Mac
or Ginnie Mae, we believe we can mitigate our exposure to losses from credit
risk.
In addition to the strategies described above, we intend to use other
strategies to seek to generate earnings and distributions to our stockholders,
which may include the following:
- increasing the size of our balance sheet at a rate faster than the rate
of increase in our operating expenses;
- using leverage to increase the size of our balance sheet; and
- lowering our effective borrowing costs over time by seeking direct
funding with collateralized lenders.
We are externally managed and advised by Seneca Capital Management LLC, or
Seneca, pursuant to a management agreement with Seneca. We have a full-time
chief financial officer, who is not employed by Seneca, to provide us with
dedicated financial management, analysis and investor relations capability.
We will elect to be taxed as a REIT under the Internal Revenue Code of
1986, as amended, commencing with the taxable year ended December 31, 2003. As
such, we will routinely distribute substantially all of the income generated
from our operations to our stockholders. As long as we retain our REIT status,
we generally will not be subject to U.S. federal or state taxes on our income to
the extent that we distribute our net income to our stockholders.
Our principal offices are located at 909 Montgomery Street, Suite 500, San
Francisco, California 94133. Our telephone number is (415) 486-2110.
RECENT DEVELOPMENTS
For the quarter ended December 31, 2003, we reported net income of $5.4
million, or $0.40 diluted earnings per share, based on 13,414,260
weighted-average shares outstanding. For the period from April 26, 2003 through
December 31, 2003, our net income was $2.8 million, or $0.27 diluted earnings
per share, based on 10,139,811 weighted-average shares outstanding. These
results are calculated in accordance
2
with accounting principles generally accepted in the United States, which are
known as GAAP. REIT taxable net income is calculated according to the
requirements of the Internal Revenue Code, rather than GAAP. As such, certain
balances, including net capital losses and other compensation and organizational
expenses, are added back for the purposes of calculating REIT taxable net
income. A reconciliation of our REIT taxable net income to our GAAP net income
for the period from April 26, 2003 through December 31, 2003 appears on page 62
of this prospectus.
For the quarter ended December 31, 2003, the weighted-average yield on
average earning assets, net of amortization of premium, was 2.81% and the
weighted-average interest rate on our repurchase agreement liabilities was
1.20%, resulting in a net interest spread of 1.61%.
At December 31, 2003, our book value was $282.5 million, or $11.38 per
share, based on 24,814,000 shares outstanding. As of December 31, 2003, the
accumulated other comprehensive loss related to the fair market value adjustment
for our mortgage-backed securities was $26.3 million. Our book value at December
31, 2003 includes the impact of the cash distribution of $0.45 per share for the
fourth quarter. At December 31, 2003, our outstanding repurchase agreement
balance was $1.7 billion, equating to leverage of 6.1 (defined as our total debt
divided by stockholders' equity), with a weighted-average interest rate of
1.19%. At December 31, 2003, the outstanding repurchase agreements had a
weighted-average maturity of approximately 145 days. After consideration of the
duration on our Eurodollar futures contracts, the weighted-average maturity of
our total liabilities was 255 days.
At December 31, 2003, the weighted-average coupon of our mortgage-related
assets was 4.09%. The constant prepayment rate, or CPR, on our mortgage-backed
securities was 23% for the quarter ended December 31, 2003. CPR declined over
the course of the fourth quarter. CPR is a measure of the rate of prepayment for
our mortgage-backed securities, expressed as an annual rate relative to the
outstanding principal balance of our mortgage-backed securities.
As of December 31, 2003, the weighted-average effective duration of the
securities in our overall investment portfolio, assuming constant prepayment
rates to the balloon or reset date, or the CPB duration, was 1.75 years. CPB is
similar to CPR except that it also assumes that the hybrid adjustable-rate
mortgage-backed securities prepay in full at their next reset date. As of
December 31, 2003, the mortgages underlying our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities had fixed interest rates for a
weighted-average of approximately 40 months, after which time the interest rates
reset and become adjustable. The average length of time until final maturity of
those mortgages was 30 years. Those mortgages are also subject to interest rate
caps that limit the amount that the applicable interest rate can increase during
any year, known as an annual cap, and through the maturity of the applicable
security, known as a lifetime cap. As of December 31, 2003, the mortgages
underlying our adjustable-rate and hybrid adjustable-rate mortgage-backed
securities had average annual caps of 2.38% and average lifetime caps of 9.99%.
At December 31, 2003, approximately 63.2% of our assets were invested in
agency securities with the remaining 36.8% invested in AAA-rated, securitized,
residential whole loan mortgages. Mortgage-related assets held at December 31,
2003 were approximately $2.2 billion and were allocated as follows:
- 8.6% in adjustable-rate mortgage-backed securities;
- 88.9% in hybrid adjustable-rate mortgage-backed securities;
- 2.5% in one balloon mortgage-backed security which matures in January
2008; and
- 0.0% in fixed rate mortgage-backed securities.
As of December 31, 2003, all of the mortgage-backed securities in our
portfolio had been purchased at a premium and the portfolio had an average
amortized cost of 102.2% of face amount.
3
The following table sets forth some of our selected unaudited financial
results for the two months ended February 29, 2004:
FOR THE TWO
MONTHS ENDED
FEBRUARY 29, 2004
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) ------------------
STATEMENT OF OPERATIONS DATA:
Net interest income.................................... $ 8,431
Net income............................................. 7,456
Basic and diluted earnings per share................... $ 0.30
BALANCE SHEET DATA (END OF PERIOD)
Total mortgage-backed securities, at fair value........ $ 2,790,736
Repurchase agreement liabilities....................... 2,497,480
Accumulated other comprehensive loss................... (10,225)
Total stockholders' equity............................. 306,343
FINANCIAL RATIOS:
Weighted-average coupon on mortgage-backed
securities............................................ 4.10%
Weighted-average yield on average earning assets....... 3.16%
Cost of funds on repurchase agreement liabilities...... 1.18%
Net interest spread.................................... 1.98%
CPR (constant prepayment rate)......................... 18%
Leverage ratio (period end)............................ 8.2
Average amortized cost of mortgage-backed securities
(period end).......................................... 101.98%
Book value per share...................................... $ 12.33
Number of shares outstanding (end of period).............. 24,841,146
On March 9, 2004 our board of directors declared a cash distribution of
$0.42 per share for the first quarter of 2004, which will be paid on April 26,
2004 to stockholders of record on March 19, 2004. The aggregate amount of our
first quarter 2004 distribution will be $10.4 million. This public offering will
close after the distribution record date and, accordingly, purchasers of common
stock in this offering will not receive this distribution. Although our results
of operations for the three months ending March 31, 2004 cannot be definitely
predicted at this time, we expect that this cash distribution will be funded
with cash flow from our ongoing operations and not with any portion of the
proceeds from this offering. Our current portfolio generates a monthly cash flow
significantly in excess of this distribution payable amount. For example, for
the three months ended February 29, 2004, we received from our portfolio
combined coupon cash flow and principal payments in the amount of $126.0
million, for an average of $42.0 million per month.
We engaged in short sales of Eurodollar futures contracts in order to hedge
the impact of changes in interest rates on our liability costs. As of March 29,
2004, we had sold short 5,680 Eurodollar futures contracts, which expire in June
2004, September 2004, and December 2004, with a notional amount totaling $5.7
billion. The value of these futures contracts is marked-to-market daily in our
margin account with the custodian. Based upon the daily market value of these
futures contracts, we either receive funds into, or wire funds into, our margin
account with the custodian to ensure that an appropriate margin account balance
is maintained at all times through the expiration of the contracts. Between
December 31, 2003 and March 29, 2004, we realized $416 thousand in losses upon
the expiration or closeout of our March 2004 Eurodollar futures contracts. As of
March 29, 2004, the unrealized loss on our remaining Eurodollar futures
contracts was $3.0 million.
These contracts have been designated as cash flow hedges of our borrowings
under repurchase agreements under Statement of Financial Accounting Standards,
or SFAS, No. 133, Accounting for Derivative Instruments and Hedging Activities,
as amended and interpreted, and therefore we have applied
4
hedge accounting to these transactions. The futures contracts are carried on the
balance sheet at fair value with the resulting gain or loss (whether realized or
unrealized) associated with the effective portion of the hedge recognized in
accumulated other comprehensive income or loss until the quarter following
contract expiration. The gain or loss associated with the ineffective portion
will be recognized in earnings in the current quarter when the effectiveness
measurement is made.
Under SFAS No. 133 and our hedging policy, at the inception and during the
life of a hedging relationship, the hedge must be expected to be highly
effective in offsetting changes in the hedged item's fair value or the
variability in cash flows attributable to the hedged risk. In applying our
policy, we have determined that these contracts are highly effective as follows.
We use regression methodology to assess the effectiveness of our hedging
strategies. Specifically, at the inception of each new hedge and on an ongoing
basis, we assess effectiveness using "ordinary least squares" regression to
evaluate the correlation between the rates consistent with the hedges and the
underlying hedged items. A hedge is highly effective if the changes in the fair
value of the derivative provide offset of at least 80% and not more than 120% of
the changes in fair value or cash flows of the hedged item attributable to the
risk being hedged.
RISK FACTORS
An investment in our common stock involves material risks, including a
number of potential conflicts of interests between us, on the one hand, and
Seneca and its affiliates, on the other hand. Each prospective purchaser of our
common stock should consider carefully the matters discussed under "Risk
Factors" beginning on page 11 of this prospectus before investing in our common
stock. Some of the risks include:
- We commenced operations in June 2003 and have a limited operating
history. Our manager, Seneca, has limited experience managing a REIT.
Accordingly, we might not be able to operate our business or implement
our operating policies and strategies successfully.
- We have not identified any specific mortgage-backed securities to acquire
with the net proceeds of this offering. Accordingly, you will not have
the opportunity to review the assets we will acquire with the net
proceeds of this offering prior to your investment. In addition, we may
not be able to acquire such assets on a timely basis or upon favorable
terms.
- We may enter into ineffective derivative transactions or other hedging
activities that may reduce our net interest income or cause us to suffer
losses.
- Interest rate mismatches between our mortgage-backed securities and our
borrowings used to fund our purchases of mortgage-backed securities might
reduce our net income or result in a loss during periods of changing
interest rates.
- Increased levels of prepayments on the mortgages underlying our
mortgage-backed securities might decrease our net interest income or
result in a net loss.
- We generally seek to borrow eight to 12 times the amount of our equity.
Such leveraging could reduce our net income and our cash available for
distributions or cause us to suffer losses.
- Our investment strategy permits us to invest up to 10% of our assets in
unrated mortgage-related assets, including mortgage-backed securities
rated below investment grade. These assets carry an increased likelihood
of default or rating downgrade relative to investment-grade assets, which
may cause us to suffer losses.
- Our board of directors may change our operating policies and strategies
without prior notice to you or stockholder approval and such changes
could harm our business and results of operations and the value of our
stock.
- Our results may suffer as a consequence of a potential conflict of
interest arising out of our relationship with our manager, on the one
hand, and our manager's relationship with other third parties, on the
other hand. In addition, this potential conflict may reduce the amount of
time and
5
effort that our manager devotes to managing our business and may result
in suitable investment opportunities being allocated to other entities.
- We pay our manager incentive compensation based on our portfolio's
performance. Accordingly, our manager may recommend riskier or more
speculative investments in an effort to maximize its incentive
compensation.
OUR MANAGER AND EXECUTIVE OFFICERS
Our day-to-day operations are externally managed and advised by our
manager, Seneca, subject to the direction and oversight of our board of
directors. Established in 1989, Seneca is a registered investment adviser under
the Investment Advisers Act of 1940, as amended. Seneca engages in investment
management as its sole business and manages fixed-income and equity assets for
pension and profit-sharing plans, financial institutions, such as banking and
insurance companies, and mutual funds for retail and institutional investors.
Seneca had over 100 full-time employees and approximately $14 billion of
institutional and private investment accounts at December 31, 2003.
From time to time, we will assess whether we should be internally managed.
Our assessment will be based on a number of factors deemed relevant by our board
of directors, including our ability to attract and retain full-time employees
and the costs and expenses related to becoming internally managed.
A majority of the outstanding equity interests of Seneca are owned by
Phoenix Investment Partners, Ltd. Phoenix Investment is a wholly-owned
subsidiary of The Phoenix Companies, Inc. (NYSE: PNX). Our board of directors
consists of seven members, five of whom are not affiliated with Seneca or
Phoenix. Neither this prospectus nor this offering are endorsed or guaranteed in
any way by Seneca or Phoenix.
Our executive officers have significant experience in providing investment
advisory services, with an average of 17 years of experience. Prior to founding
Seneca, Gail P. Seneca, our chief executive officer, spent two years as senior
vice president of the Asset Management Division of Wells Fargo Bank, where she
managed fixed-income assets in excess of $10 billion. Before joining Seneca as
its fixed income chief investment officer, Albert J. Gutierrez, our president,
spent two years as head of portfolio management, trading and investment systems
at American General Investment Management, where he was responsible for
approximately $75 billion in client assets, and 12 years with Conseco Capital
Management as a senior vice president in charge of fixed income research and
trading as well as insurance asset portfolio management. Other than our
full-time chief financial officer, all of our executive officers are also
employees and/or officers of Seneca, as described in the following table:
NAME POSITION WITH SENECA POSITION WITH US
---- -------------------- ----------------
Gail P. Seneca, Ph.D. President/Chief Executive Officer Chairman of the Board of Directors
and Chief Investment Officer and Chief Executive Officer
Albert J. Gutierrez, CFA Fixed Income Chief Investment President and Director
Officer and Principal
Christopher J. Zyda None Senior Vice President and Chief
Financial Officer
Andrew S. Chow, CFA Fixed Income Portfolio Manager Senior Vice President
Troy A. Grande, CFA Fixed Income Portfolio Manager Senior Vice President
THE MANAGEMENT AGREEMENT
We have entered into a management agreement with Seneca dated June 11,
2003. Pursuant to the management agreement, Seneca, as our sole manager,
generally implements our business strategy, is responsible for our day-to-day
operations and performs services and activities relating to our assets and
6
operations in accordance with the terms of the management agreement. Seneca's
services for us can be divided into the following three main activities:
- Asset Management -- Seneca advises us with respect to, arranges for and
manages the acquisition, financing, management and disposition of, our
investments.
- Liability Management -- Seneca evaluates the credit risk and prepayment
risk of our investments and arranges borrowing and hedging strategies.
- Capital Management -- Seneca coordinates our capital raising activities.
In conducting these activities, Seneca advises us on the formulation of,
and implements, our operating strategies and policies, arranges for our
acquisition of assets, monitors the performance of our assets, arranges for
various types of financing and hedging strategies, and provides administrative
and managerial services in connection with our operations. At all times in the
performance of these activities, Seneca is subject to the direction and
oversight of our board of directors.
Pursuant to the management agreement and a cost-sharing agreement between
Seneca and us, Seneca may earn or be entitled to receive the following
compensation, fees and other benefits:
- Base management fee -- 1% per annum of the first $300 million of our
average net worth, plus 0.8% per annum of our average net worth in excess
of $300 million during such fiscal year, calculated on a quarterly basis;
- Incentive compensation -- a specified percentage of our REIT taxable net
income (before deducting incentive compensation, net operating losses and
certain other items) in excess of a threshold amount of taxable income,
calculated on a quarterly basis and subject to annual reconciliation;
- Out-of-pocket expense reimbursements -- reimbursement of actual
out-of-pocket expenses incurred in connection with our administration on
an ongoing basis;
- Reimbursement of overhead expenses -- reimbursement of actual costs
attributable to our use of services rendered by Seneca pursuant to the
cost-sharing agreement. Our portion of such costs is allocated to us as
determined by Seneca, subject to reasonable approval by a majority of our
independent directors; and
- Termination fee -- payable only upon termination by us without cause or
by Seneca upon our change of control. Actual amount of fee depends on the
circumstances of the termination.
For a more detailed discussion of the compensation and other fees payable
to Seneca, see the sections titled "The Manager -- The Management Agreement" and
"The Manager -- The Cost-Sharing Agreement."
CONFLICTS OF INTEREST
We are subject to potential conflicts of interest involving Seneca and its
affiliates because, among other reasons:
- the incentive compensation, which is based on our net income, may create
an incentive for Seneca to recommend investments with greater income
potential, which may be relatively more risky than would be the case if
its compensation from us did not include an incentive-based component;
- Seneca and its affiliates are permitted to purchase mortgage-backed
securities for their own account and to advise accounts of other clients,
and certain investment opportunities appropriate for us also will be
appropriate for these accounts; and
- two of our directors, and all but one of our executive officers, are
managers or employees of, or otherwise affiliated with, Seneca.
7
For a more detailed discussion of potential conflicts of interests between
us, on the one hand, and Seneca and its affiliates, on the other hand, see the
section titled "Conflicts of Interests; Certain Relationships and Related
Transactions."
The management agreement does not limit or restrict the right of Seneca or
any of its affiliates from engaging in any business or rendering services to any
other person, including, without limitation, the purchase of, or rendering
advice to others purchasing, mortgage-backed securities that meet our investment
guidelines. However, Seneca has agreed that for as long as Seneca is our
exclusive manager pursuant to the management agreement, it will not sponsor any
other mortgage REIT that invests primarily in high-quality, residential
mortgage-backed securities, without first obtaining the approval of a majority
of our independent directors.
THIS OFFERING
Common stock offered by us....... 12,000,000 shares.
Common stock to be outstanding
after this offering.............. 36,841,146 shares.
Use of proceeds.................. We intend to invest our net proceeds of
this offering (after offering expenses and
underwriting discounts and commissions) to
expand our portfolio of mortgage-related
assets, primarily U.S. agency and other
highly-rated, single-family,
adjustable-rate and fixed-rate
mortgage-backed securities. Until such
assets can be identified and obtained, we
intend to temporarily invest the balance of
the proceeds of this offering in readily
marketable interest-bearing assets
consistent with our intention to qualify as
a REIT. We estimate that the expenses of
this offering (excluding underwriting
discounts and commissions) will be
approximately $400,000. See "Use of
Proceeds."
Trading.......................... Our common stock is listed on the NYSE
under the symbol "LUM."
The number of shares of our common stock to be outstanding after this
offering, above, is based on 24,841,146 shares outstanding on March 29, 2004,
and excludes:
- 55,000 shares of our common stock issuable upon the exercise of options
outstanding on March 29, 2004 with a weighted-average exercise price of
$14.82 per share;
- 943,505 additional shares of our common stock as of March 29, 2004
available for issuance under our 2003 stock incentive plan and 2003
outside advisors stock incentive plan; and
- up to 1,800,000 shares of our common stock that may be issued by us upon
exercise of the underwriters' over-allotment option.
OUR TAX STATUS
We will elect to be taxed as a REIT under the Internal Revenue Code
commencing with our taxable year ending December 31, 2003. Provided we qualify
as a REIT, we generally will not be subject to U.S. federal corporate income tax
on taxable income that we distribute to our stockholders. REITs are subject to a
number of organizational and operational requirements, including a requirement
that they currently distribute at least 90% of their annual REIT net taxable
income. We face the risk that we might not be able to comply with all of the
REIT requirements in the future. Failure to qualify as a REIT would render us
subject to U.S. federal income tax (including any applicable alternative minimum
tax) on our taxable income at regular corporate rates, and distributions to our
stockholders would not be deductible. Even if we qualify for taxation as a REIT,
we may be subject to certain U.S. federal, state, local and foreign taxes on our
income and property. See "United States Federal Income Tax Considerations."
8
RESTRICTIONS ON OWNERSHIP OF OUR STOCK
In order to facilitate our qualification as a REIT, our charter prohibits
any stockholder from directly or indirectly owning more than 9.8% of the
outstanding shares of any class or series of our stock. We adopted this
restriction to promote compliance with the provisions of the Internal Revenue
Code which limit the degree to which ownership of a REIT may be concentrated.
See "Description of Capital Stock -- Transfer Restrictions."
DISTRIBUTIONS
To avoid corporate income and excise tax and to maintain our qualification
as a REIT, we intend to make quarterly distributions to our stockholders that
will result in annual distributions of at least 90% of our REIT net taxable
income, determined without regard to the deduction for dividends paid and by
excluding any net capital gains. REIT net taxable income is calculated pursuant
to standards in the Internal Revenue Code and will not necessarily be the same
as our net income as calculated in accordance with GAAP. Our board of directors
may, in its discretion, cause us to make additional distributions of cash
legally available for that purpose. Our distributions from quarter to quarter
will depend on our taxable earnings, financial condition and such other factors
as our board of directors deems relevant. In the future, our board of directors
may elect to adopt a dividend reinvestment plan.
RESALE REGISTRATION STATEMENT AND LOCK-UP AGREEMENTS
Resale Registration Statement. A registration statement covering the
resale of up to 11,500,000 shares of our common stock that were issued in our
June 2003 private placement was declared effective by the Securities and
Exchange Commission, or the SEC, on February 13, 2004. We have agreed to use our
commercially reasonable efforts to keep the resale registration statement
effective until the date on which no "registrable shares" (as defined in the
registration rights agreement) remain outstanding, which will generally occur
when all of the privately placed shares have either been resold in a registered
sale or are eligible for resale under Rule 144. In addition, our obligation to
keep the resale registration statement effective is subject to specified,
permitted exceptions. We may suspend the selling stockholders' use of the resale
prospectus and offers and sales of the shares of our common stock pursuant to
the resale prospectus for a period not to exceed 60 days in any 90-day period,
and not to exceed an aggregate of 60 days in any 12-month period commencing on
June 11, 2003, if our board makes a good faith determination that a suspension
is in our best interests. If we do not make certain filings with the SEC in
accordance with the registration rights agreement, subject to the permitted
suspension periods, we may be required to hold in a segregated, interest-bearing
account in trust for, and not to release to, Seneca the incentive compensation
otherwise payable to Seneca under the management agreement until we have made
the requisite filings.
Lock-Up Agreements. In connection with this offering, each of our
directors and officers and Seneca, who will own an aggregate of 415,909 shares
of our common stock immediately after this offering, have entered into
individual lock-up agreements. These lock-up agreements will, subject to various
exceptions, prevent them from reselling their shares until June 28, 2004, which
is the 91st day after the date of this prospectus. However, 10,261 of these
shares are subject to additional transfer restrictions and will not be available
for sale until after such date.
9
SUMMARY FINANCIAL DATA
The following summary financial data are derived from audited financial
statements as of December 31, 2003 and for the period from April 26, 2003
through December 31, 2003. The selected financial data should be read in
conjunction with the more detailed information contained in the financial
statements and notes thereto and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" included elsewhere in this
prospectus.
FOR THE PERIOD
FROM APRIL 26,
2003 THROUGH
DECEMBER 31, 2003
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) -----------------
STATEMENT OF OPERATIONS DATA:
Revenues:
Net interest income:
Interest income........................................... $ 22,654
Interest expense.......................................... 9,009
-----------
Net interest income.................................... 13,645
Losses on sales of mortgage-backed securities............. (7,831)
Expenses:
Management fee expense to related party................... 901
Incentive fee expense to related party.................... 980
Salaries and benefits..................................... 99
Professional services..................................... 477
Board of directors expense................................ 117
Insurance expense......................................... 291
Custody expense........................................... 115
Other general and administrative expenses................. 73
-----------
Total expenses......................................... 3,053
-----------
Net income.................................................. $ 2,761
===========
Basic and diluted earnings per share........................ $ 0.27
===========
Weighted-average number of shares outstanding, basic........ 10,139,280
===========
Weighted-average number of shares outstanding, diluted...... 10,139,811
===========
DECEMBER 31, 2003
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) -----------------
BALANCE SHEET DATA:
Mortgage-backed securities available-for-sale, at fair
value..................................................... $ 352,123
Mortgage-backed securities available-for-sale, pledged as
collateral, at fair value................................. 1,809,822
Total mortgage-backed securities available-for-sale, at fair
value..................................................... 2,161,945
Total assets................................................ 2,179,340
Repurchase agreements and margin debt....................... 1,728,973
Unsettled security purchases................................ 156,127
Total liabilities........................................... 1,896,844
Accumulated other comprehensive loss........................ (26,510)
Total stockholders' equity.................................. 282,496
Book value per share........................................ $ 11.38
10
RISK FACTORS
You should carefully consider the risks described below before making an
investment decision. Our business, financial condition or results of operations
could be harmed by any of these risks. Similarly, these risks could cause the
market price of our common stock to decline and you might lose all or part of
your investment. Our forward-looking statements in this prospectus are subject
to the following risks and uncertainties. Our actual results could differ
materially from those anticipated by our forward-looking statements as a result
of the risk factors below. The risks described below are not the only ones
facing our company. Additional risks not presently known to us or that we
currently deem immaterial might also impair our business operations.
RISKS RELATED TO OUR BUSINESS
WE HAVE A LIMITED OPERATING HISTORY AND MIGHT NOT BE ABLE TO OPERATE OUR
BUSINESS OR IMPLEMENT OUR OPERATING POLICIES AND STRATEGIES SUCCESSFULLY.
We began operations in June of 2003, and we have a limited operating
history. The results of our operations will depend on many factors, including
the availability of opportunities for the acquisition of mortgage-related
assets, the level and volatility of interest rates, readily accessible short-and
long-term funding alternatives in the financial markets and economic conditions.
Moreover, delays in fully leveraging and investing our net proceeds of this
offering may cause our performance to be weaker than other fully leveraged and
invested mortgage REITs pursuing comparable investment strategies. You will not
have the opportunity to evaluate the manner in which we invest or the economic
merits of particular assets to be acquired. Furthermore, we face the risk that
we might not successfully operate our business or implement our operating
policies and strategies as described in this prospectus.
WE HAVE NOT YET IDENTIFIED ANY SPECIFIC MORTGAGE-BACKED SECURITIES TO PURCHASE
WITH THE NET PROCEEDS OF THIS OFFERING AND MAY BE UNABLE TO INVEST A
SIGNIFICANT PORTION OF SUCH NET PROCEEDS ON ACCEPTABLE TERMS OR AT ALL, WHICH
COULD HARM OUR FINANCIAL CONDITION AND OPERATING RESULTS.
As of the date of this prospectus, we have not identified any specific
mortgage-backed securities that we intend to acquire with the proceeds from this
offering. As a result, you will not be able to evaluate the economic merits of
any investments we make with the net proceeds of this offering prior to the
purchase of your shares. You must rely on our ability to evaluate our investment
opportunities. Until we identify and acquire mortgage-backed securities
consistent with our investment guidelines, we intend to temporarily invest the
balance of the net proceeds of this offering in readily marketable
interest-bearing assets consistent with our intention to qualify as a REIT. We
cannot assure you that we will be able to identify mortgage-related assets that
meet our investment guidelines or that any investment that we make will produce
a positive return on our investment. We may be unable to invest the net proceeds
of this offering on acceptable terms or at all.
WE MIGHT NOT BE ABLE TO USE DERIVATIVES TO MITIGATE OUR INTEREST RATE AND
PREPAYMENT RISKS.
Our policies permit us to enter into interest rate swaps, caps and floors
and other derivative transactions to help us reduce our interest rate and
prepayment risks. As of December 31, 2003, we sold short 2,090 Eurodollar
futures contracts in order to hedge the impact of changes in interest rates on
our liability costs. The following table summarizes the expiration dates of
these Eurodollar futures contracts and their notional amounts as of December 31,
2003 (in thousands):
EXPIRATION DATE NOTIONAL AMOUNT
--------------- ---------------
March 2004.................................................. $ 880,000
June 2004................................................... 605,000
September 2004.............................................. 605,000
----------
Total....................................................... $2,090,000
==========
11
Subsequent to December 31, 2003 through March 29, 2004, we have sold short
an additional 4,470 Eurodollar futures contracts. These contracts expire in June
2004, September 2004 and December 2004 and have a notional amount totaling $2.0
billion, $1.6 billion and $840.0 million, respectively. In addition, we realized
$416 thousand in losses subsequent to December 31, 2003 through March 29, 2004
upon expiration or closeout of our March 2004 Eurodollar future contracts.
In the future, these transactions might mitigate our interest rate and
prepayment risks, but cannot eliminate these risks. Moreover, the use of
derivative transactions could have a negative impact on our earnings and our
status as a REIT, and, therefore, our use of such derivatives could be limited.
WE MAY ENTER INTO INEFFECTIVE DERIVATIVE TRANSACTIONS OR OTHER HEDGING
ACTIVITIES THAT MAY REDUCE OUR NET INTEREST INCOME OR CAUSE US TO SUFFER
LOSSES.
Our policies permit us to, but we are not required to, enter into
derivative transactions such as interest rate swaps, caps and floors and other
derivative transactions to help us seek to reduce our interest rate and
prepayment risks. The effectiveness of any derivative transactions will depend
significantly upon whether we correctly quantify the interest rate or prepayment
risks being hedged, our execution of and ongoing monitoring of our hedging
activities, and the treatment of such hedging activities for GAAP accounting
purposes.
As of December 31, 2003, we sold short 2,090 Eurodollar futures contracts
with a notional amount totaling $2.1 billion in order to hedge the impact of
changes in interest rates on our liability costs. In the case of these hedges,
and any other future efforts to hedge the effects of interest rate changes on
our liability costs, if we enter into hedging instruments that have higher
interest rates embedded in them as a result of the forward yield curve, and at
the end of the term of these hedging instruments the spot market interest rates
for the liabilities that we hedged are actually lower, then we will have locked
in higher interest rates for our liabilities than would be available in the spot
market at the time and this could result in a narrowing of our net interest rate
margin or result in losses. In some situations, we may sell assets or hedging
instruments at a loss in order to maintain adequate liquidity.
In addition, we apply SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities, as amended and interpreted, and record derivatives at
fair value. If the derivatives meet the criteria to be accounted for as hedging
transactions, the effects of the transactions could be materially different as
to timing than if they do not qualify as hedges, and this may cause a narrowing
of our net interest rate margin or result in losses.
OUR INVESTMENT GUIDELINES PERMIT US TO INVEST UP TO 10% OF OUR ASSETS IN
UNRATED MORTGAGE-RELATED ASSETS, INCLUDING MORTGAGE-BACKED SECURITIES RATED
BELOW INVESTMENT-GRADE, WHICH CARRY A GREATER LIKELIHOOD OF DEFAULT OR RATING
DOWNGRADE THAN INVESTMENTS IN INVESTMENT-GRADE MORTGAGE-BACKED SECURITIES AND
MAY CAUSE US TO SUFFER LOSSES.
Our asset acquisition policy provides us with the ability to acquire
significant amounts of lower credit quality mortgage-related assets, including
mortgage-backed securities that are not rated at least investment grade by at
least one nationally-recognized statistical rating organization. Under our
policy, up to 10% of our total assets may be non-investment grade
mortgage-backed securities or other investments such as leveraged mortgage
derivative securities, shares of other REITs, mortgage loans or other
mortgage-related investments. If we acquire non-investment-grade mortgage-backed
securities, we are more likely to incur losses because the mortgages underlying
those securities are made to borrowers possessing lower-quality credit. While
all agency certificates are subject to a risk of default, that risk is greater
with non-investment grade mortgage-backed securities. In addition, the rating
agencies are more likely to downgrade the credit quality of those securities,
which would reduce the value of those securities.
12
INTEREST RATE MISMATCHES BETWEEN OUR ADJUSTABLE-RATE AND HYBRID
ADJUSTABLE-RATE MORTGAGE-BACKED SECURITIES AND THE BORROWINGS USED TO FUND OUR
PURCHASES OF SUCH MORTGAGE-BACKED SECURITIES MIGHT REDUCE OUR NET INCOME OR
RESULT IN A LOSS DURING PERIODS OF CHANGING INTEREST RATES.
We invest primarily in adjustable-rate and hybrid adjustable-rate
mortgage-backed securities. The mortgages underlying adjustable-rate
mortgage-backed securities have interest rates that reset periodically,
typically every six months or on an annual basis, based upon market-based
indices of interest rates such as U.S. Treasury bonds or LIBOR. The mortgages
underlying hybrid adjustable-rate mortgage-backed securities have interest rates
that are fixed for the first few years of the loan -- typically three, five,
seven or 10 years -- and thereafter their interest rates reset periodically
similar to the mortgages underlying adjustable-rate mortgage-backed securities.
We have funded our acquisitions and expect to fund our future acquisitions of
adjustable-rate and hybrid adjustable-rate mortgage-backed securities in part
with borrowings that have interest rates based on indices and repricing terms
similar to, but with shorter maturities than, the interest rate indices and
repricing terms of the adjustable-rate and hybrid adjustable-rate
mortgage-backed securities. On December 31, 2003, 97.5% of our investment
portfolio was invested in adjustable-rate or hybrid adjustable-rate
mortgage-backed securities having a weighted-average term to next rate
adjustment of approximately 40 months, while our borrowings had a
weighted-average term of approximately 145 days. After consideration of the
duration on our Eurodollar futures contracts, our weighted-average maturity was
255 days. The phrase "weighted-average term to next rate adjustment" refers to
the average of the periods of time that must elapse before the interest rates
adjust for all of the mortgages underlying our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities in our portfolio, which average is
weighted in proportion to the book values of the applicable securities. During
periods of changing interest rates, this interest rate mismatch between our
assets and liabilities could reduce or eliminate our net income and
distributions to our stockholders and could cause us to suffer a loss.
Accordingly, in a period of rising interest rates, we could experience a
decrease in, or elimination of, net income or a net loss because the interest
rates on our borrowings adjust faster than the interest rates on our
adjustable-rate mortgage-backed securities.
INCREASED LEVELS OF PREPAYMENTS ON THE MORTGAGES UNDERLYING OUR
MORTGAGE-BACKED SECURITIES MIGHT DECREASE OUR NET INTEREST INCOME OR RESULT IN
A NET LOSS.
The mortgage-backed securities that we acquire generally represent
interests in pools of mortgage loans. The principal and interest payments we
receive from our mortgage-backed securities are generally funded by the payments
that mortgage borrowers make on those underlying mortgage loans. When borrowers
pre-pay their mortgage loans sooner than expected, corresponding prepayments on
the mortgage-backed securities occur sooner than expected by the marketplace.
Sooner-than-expected prepayments could harm our results of operations in the
following ways, among others:
- We seek to purchase mortgage-backed securities that we believe to have
favorable risk-adjusted expected returns relative to market interest
rates at the time of purchase. If the coupon interest rate for a
mortgage-backed security is higher than the market interest rate at the
time it is purchased, then that mortgage-backed security will be acquired
at a premium to its par value. In accordance with applicable accounting
rules, we are required to amortize any premiums or discounts related to
our mortgage-backed securities over their expected terms. The
amortization of a premium reduces interest income, while the amortization
of a discount increases interest income. The expected terms for
mortgage-backed securities are a function of the prepayment rates for the
mortgages underlying the mortgage-backed securities. Mortgage-backed
securities that are at a premium to their par value are more likely to
experience prepayment of some or all of their principal through
refinancings. If the mortgages underlying our premium mortgage-backed
securities are prepaid in whole or in part more quickly than their
respective maturity dates, then we must also amortize their respective
premiums more quickly, which would decrease our net interest income and
harm our profitability.
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- A substantial portion of our adjustable-rate mortgage-backed securities
may bear interest at rates that are lower than their "fully-indexed
rates," which refers to their applicable index rates plus a margin. If an
adjustable-rate mortgage-backed security is prepaid prior to or soon
after the time of adjustment to a fully-indexed rate, we will have held
that mortgage-backed security while it was less profitable and lost the
opportunity to receive interest at the fully-indexed rate over the
remainder of its expected life.
- If we are unable to acquire new mortgage-backed securities to replace the
prepaid mortgage-backed securities, our financial condition, results of
operations and cash flow may suffer and we could incur losses.
Prepayment rates generally increase when interest rates fall and decrease
when interest rates rise, but changes in prepayment rates are difficult to
predict. Prepayment rates also may be affected by other factors, including,
without limitation, conditions in the housing and financial markets, general
economic conditions and the relative interest rates on adjustable-rate and
fixed-rate mortgage loans. While we seek to minimize prepayment risk, we must
balance prepayment risk against other risks and the potential returns of each
investment when selecting investments. No strategy can completely insulate us
from prepayment or other such risks.
WE MAY INCUR INCREASED BORROWING COSTS RELATED TO REPURCHASE AGREEMENTS THAT
WOULD HARM OUR RESULTS OF OPERATIONS.
Our borrowing costs under repurchase agreements are generally adjustable
and correspond to short-term interest rates, such as LIBOR or a short-term
Treasury index, plus or minus a margin. The margins on these borrowings over or
under short-term interest rates may vary depending upon a number of factors,
including, without limitation:
- the movement of interest rates;
- the availability of financing in the market; and
- the value and liquidity of our mortgage-backed securities.
Most of our borrowings are collateralized borrowings in the form of
repurchase agreements. If the interest rates on these repurchase agreements
increase, our results of operations will be harmed and we may have losses.
INTEREST RATE CAPS RELATED TO OUR ADJUSTABLE-RATE AND HYBRID ADJUSTABLE-RATE
MORTGAGE-BACKED SECURITIES MAY REDUCE OUR INCOME OR CAUSE US TO SUFFER A LOSS
DURING PERIODS OF RISING INTEREST RATES.
The mortgages underlying our adjustable-rate and hybrid adjustable-rate
mortgage-backed securities are typically subject to periodic and lifetime
interest rate caps. Periodic interest rate caps limit the amount that the
interest rate of a mortgage can increase during any given period. Lifetime
interest rate caps limit the amount an interest rate can increase through the
maturity of a mortgage. As of December 31, 2003, 97.5% of our mortgage-backed
securities were based on adjustable-rate or hybrid adjustable-rate mortgages,
substantially all of which were subject to interest rate caps. The percentage of
adjustable-rate and hybrid adjustable-rate mortgage-backed securities in our
investment portfolio as of December 31, 2003 which are subject to periodic
interest rate caps every six months or annually were 16.6% and 80.9%,
respectively.
Our borrowings are not subject to similar restrictions. The periodic
adjustments to the interest rates of the mortgages underlying our
adjustable-rate and hybrid adjustable-rate mortgage-backed securities are based
on changes in an objective index. Substantially all of the mortgages underlying
our adjustable-rate and hybrid adjustable-rate mortgage-backed securities adjust
their interest rates based on one of two main indices, the U.S. Treasury index,
a monthly or weekly average yield of benchmark U.S. Treasury securities as
published by the Federal Reserve Board, or LIBOR, the interest rate that banks
in London offer for deposits in London of U.S. dollars. The percentages of the
mortgages underlying the adjustable-rate and
14
hybrid adjustable-rate mortgage-backed securities in our investment portfolio as
of December 31, 2003 with interest rates that reset based on the U.S. Treasury
or LIBOR indices were 39.1% and 58.4%, respectively.
Accordingly, in a period of rapidly increasing interest rates, the interest
rates paid on our borrowings could increase without limitation while interest
rate caps could limit the increases in the yields on our adjustable-rate and
hybrid adjustable-rate mortgage-backed securities. This problem is magnified for
adjustable-rate and hybrid adjustable-rate mortgage-backed securities that are
not fully indexed. Further, some of the mortgages underlying our adjustable-rate
and hybrid adjustable-rate mortgage-backed securities may be subject to periodic
payment caps that result in a portion of the interest being deferred and added
to the principal outstanding. As a result, we may receive less cash income on
adjustable-rate and hybrid adjustable-rate mortgage-backed securities than we
need to pay interest on our related borrowings. These factors could reduce our
net interest income or cause us to suffer a net loss.
WE MIGHT EXPERIENCE REDUCED NET INTEREST INCOME OR A LOSS FROM HOLDING
FIXED-RATE INVESTMENTS DURING PERIODS OF RISING INTEREST RATES.
A significant portion of our investment portfolio consists of hybrid
adjustable-rate mortgage-backed securities. As of December 31, 2003, 88.9% of
our investment portfolio consisted of hybrid adjustable-rate mortgage-backed
securities. We may also invest in fixed-rate mortgage-backed securities from
time to time, however, as of December 31, 2003, none of our portfolio consisted
of fixed-rate mortgage-backed securities. We fund our acquisition of fixed-rate
mortgage-backed securities, including those based on balloon maturity and hybrid
adjustable-rate mortgages, in part with short-term repurchase agreements and
term loans. During periods of rising interest rates, our costs associated with
borrowings used to fund the acquisition of fixed-rate mortgage-backed securities
are subject to increases while the income we earn from these assets remains
substantially fixed. This would reduce and could eliminate the net interest
spread between the fixed-rate mortgage-backed securities that we purchase and
our borrowings used to purchase them, which would reduce our net interest income
and could cause us to suffer a loss.
OUR LEVERAGE STRATEGY INCREASES THE RISKS OF OUR OPERATIONS, WHICH COULD
REDUCE OUR NET INCOME AND THE AMOUNT AVAILABLE FOR DISTRIBUTIONS OR CAUSE US
TO SUFFER A LOSS.
As of December 31, 2003, we had indebtedness of approximately $1.7 billion.
We generally seek to borrow between eight and 12 times the amount of our equity,
although at times our borrowings may be above or below this amount. We incur
this indebtedness by borrowing against a substantial portion of the market value
of our mortgage-backed securities. Our total indebtedness, however, is not
expressly limited by our policies and will depend on our and our prospective
lender's estimate of the stability of our portfolio's cash flow. We face the
risk that we might not be able to meet our debt service obligations or a
lender's margin requirements from our income and, to the extent we cannot, we
might be forced to liquidate some of our assets at disadvantageous prices. Our
use of leverage amplifies the risks associated with other risk factors, which
could reduce our net income and the amount available for distributions or cause
us to suffer a loss. For example:
- A majority of our borrowings are secured by our mortgage-backed
securities, generally under repurchase agreements. A decline in the
market value of the mortgage-backed securities used to secure these debt
obligations could limit our ability to borrow or result in lenders
requiring us to pledge additional collateral to secure our borrowings. In
that situation, we could be required to sell mortgage-backed securities
under adverse market conditions in order to obtain the additional
collateral required by the lender. If these sales are made at prices
lower than the carrying value of the mortgage-backed securities, we would
experience losses.
- A default under a mortgage-related asset that constitutes collateral for
a loan could also result in an involuntary liquidation of the
mortgage-related asset, including any cross-collateralized mortgage-
backed securities. This would result in a loss to us of the difference
between the value of the
15
mortgage-related asset upon liquidation and the amount borrowed against
the mortgage-related asset.
- To the extent we are compelled to liquidate qualified REIT assets to
repay debts, our compliance with the REIT rules regarding our assets and
our sources of income could be negatively affected, which would
jeopardize our status as a REIT. Losing our REIT status would cause us to
lose tax advantages applicable to REITs and would decrease our overall
profitability and distributions to our stockholders.
- If we experience losses as a result of our leverage policy, such losses
could reduce the amounts available for distribution to our stockholders.
AN INCREASE IN INTEREST RATES MIGHT HARM OUR BOOK VALUE.
We use changes in 10-year U.S. Treasury yields as a reference indicator for
changes in interest rates because it is a common market benchmark. Increases in
the general level of interest rates can cause the fair market value of our
assets to decline, particularly those mortgage-backed securities whose
underlying mortgages have fixed-rate components. Our fixed-rate mortgage
securities and our hybrid adjustable-rate mortgage-backed securities (during the
fixed-rate component of the mortgages underlying such securities) will generally
be more negatively affected by such increases than our adjustable-rate mortgage
securities. In accordance with GAAP, we will be required to reduce the carrying
value of our mortgage-backed securities by the amount of any decrease in the
fair value of our mortgage-backed securities compared to their respective
amortized costs. If unrealized losses in fair value occur, we will have to
either reduce current earnings or reduce stockholders' equity without
immediately affecting current earnings, depending on how we classify such
mortgage-backed securities under GAAP. In either case, our net book value will
decrease to the extent of any realized or unrealized losses in fair value.
WE MAY INVEST IN LEVERAGED MORTGAGE DERIVATIVE SECURITIES THAT GENERALLY
EXPERIENCE GREATER VOLATILITY IN MARKET PRICES, AND THUS EXPOSE US TO GREATER
RISK WITH RESPECT TO THEIR RATE OF RETURN.
We may acquire leveraged mortgage derivative securities that expose us to a
high level of interest rate risk. The characteristics of leveraged mortgage
derivative securities cause those securities to experience greater volatility in
their market prices. Thus, acquisition of leveraged mortgage derivative
securities will expose us to the risk of greater volatility in our portfolio,
which could reduce our net income and harm our overall results of operations.
WE DEPEND ON BORROWINGS TO PURCHASE MORTGAGE-RELATED ASSETS AND REACH OUR
DESIRED AMOUNT OF LEVERAGE. IF WE FAIL TO OBTAIN OR RENEW SUFFICIENT FUNDING
ON FAVORABLE TERMS OR AT ALL, WE WILL BE LIMITED IN OUR ABILITY TO ACQUIRE
MORTGAGE-RELATED ASSETS, WHICH WILL HARM OUR RESULTS OF OPERATIONS.
We depend on short-term borrowings to fund acquisitions of mortgage-related
assets and reach our desired amount of leverage. Accordingly, our ability to
achieve our investment and leverage objectives depends on our ability to borrow
money in sufficient amounts and on favorable terms. In addition, we must be able
to renew or replace our maturing short-term borrowings on a continuous basis. We
depend on a few lenders to provide the primary credit facilities for our
purchases of mortgage-related assets. In addition, our existing indebtedness may
limit our ability to make additional borrowings. If our lenders do not allow us
to renew our borrowings or we cannot replace maturing borrowings on favorable
terms or at all, we might have to sell our mortgage-related assets under adverse
market conditions, which would harm our results of operations and may result in
permanent losses.
POSSIBLE MARKET DEVELOPMENTS COULD CAUSE OUR LENDERS TO REQUIRE US TO PLEDGE
ADDITIONAL ASSETS AS COLLATERAL. IF OUR ASSETS ARE INSUFFICIENT TO MEET THE
COLLATERAL REQUIREMENTS, WE MIGHT BE COMPELLED TO LIQUIDATE PARTICULAR ASSETS
AT INOPPORTUNE TIMES AND AT DISADVANTAGEOUS PRICES.
Possible market developments, including a sharp or prolonged rise in
interest rates, a change in prepayment rates or increasing market concern about
the value or liquidity of one or more types of
16
mortgage-backed securities in which our portfolio is concentrated, might reduce
the market value of our portfolio, which might cause our lenders to require
additional collateral. Any requirement for additional collateral might compel us
to liquidate our assets at inopportune times and at disadvantageous prices,
thereby harming our operating results. If we sell mortgage-backed securities at
prices lower than the carrying value of the mortgage-backed securities, we would
experience losses.
OUR USE OF REPURCHASE AGREEMENTS TO BORROW FUNDS MAY GIVE OUR LENDERS GREATER
RIGHTS IN THE EVENT THAT EITHER WE OR ANY OF OUR LENDERS FILE FOR BANKRUPTCY.
Our borrowings under repurchase agreements may qualify for special
treatment under the bankruptcy code, giving our lenders the ability to avoid the
automatic stay provisions of the bankruptcy code and to take possession of and
liquidate our collateral under the repurchase agreements without delay if we
file for bankruptcy. Furthermore, the special treatment of repurchase agreements
under the bankruptcy code may make it difficult for us to recover our pledged
assets in the event that our lender files for bankruptcy. Thus, the use of
repurchase agreements exposes our pledged assets to risk in the event of a
bankruptcy filing by either our lender or us.
BECAUSE THE ASSETS THAT WE ACQUIRE MIGHT EXPERIENCE PERIODS OF ILLIQUIDITY, WE
MIGHT BE PREVENTED FROM SELLING OUR MORTGAGE-RELATED ASSETS AT OPPORTUNE TIMES
AND PRICES.
We bear the risk of being unable to dispose of our mortgage-related assets
at advantageous times and prices or in a timely manner because mortgage-related
assets generally experience periods of illiquidity. The lack of liquidity might
result from the absence of a willing buyer or an established market for these
assets, as well as legal or contractual restrictions on resale. If we are unable
to sell our mortgage-related assets at opportune times, we might suffer a loss
and/or reduce our distributions.
OUR BOARD OF DIRECTORS MAY CHANGE OUR OPERATING POLICIES AND STRATEGIES
WITHOUT PRIOR NOTICE OR STOCKHOLDER APPROVAL AND SUCH CHANGES COULD HARM OUR
BUSINESS AND RESULTS OF OPERATIONS AND THE VALUE OF OUR STOCK.
Our board of directors has the authority to modify or waive our current
operating policies and our strategies (including our election to operate as a
REIT) without prior notice and without stockholder approval. We cannot predict
the effect any changes to our current operating policies and strategies would
have on our business, operating results and value of our stock. However, the
effects might be adverse.
COMPETITION MIGHT PREVENT US FROM ACQUIRING MORTGAGE-BACKED SECURITIES AT
FAVORABLE YIELDS, WHICH WOULD HARM OUR RESULTS OF OPERATIONS.
Our net income depends on our ability to acquire mortgage-backed securities
at favorable spreads over our borrowing costs. In acquiring mortgage-backed
securities, we compete with other REITs, investment banking firms, savings and
loan associations, banks, insurance companies, mutual funds, other lenders and
other entities that purchase mortgage-backed securities, many of which have
greater financial resources than we do. As a result, we may not be able to
acquire sufficient mortgage-backed securities at favorable spreads over our
borrowing costs, which would harm our results of operations.
DEFAULTS ON THE MORTGAGE LOANS UNDERLYING OUR MORTGAGE-BACKED SECURITIES MAY
REDUCE THE VALUE OF OUR INVESTMENT PORTFOLIO AND MAY HARM OUR RESULTS OF
OPERATIONS.
We bear the risk of any losses resulting from any defaults on the mortgage
loans underlying the mortgage-backed securities in our investment portfolio.
Many of the mortgage-backed securities that we obtain will have one or more
forms of credit enhancement provided by third parties, such as insurance against
risk of loss due to default on the underlying mortgage loans or bankruptcy,
fraud and special hazard losses. To the extent that third parties have been
contracted to insure against these types of losses, the value of such insurance
will depend in part on the creditworthiness and claims-paying ability of the
insurer and the timeliness of reimbursement in the event of a default on the
underlying obligations.
17
Further, the insurance coverage for various types of losses is limited in
amount, and losses in excess of these limitations would be borne by us.
Other mortgage-backed securities that we purchase will be subject to
limited guarantees of the payment of limited amounts of principal and interest
on mortgage loans underlying such mortgage-backed securities, either by federal
government agencies, including Ginnie Mae, by federally-chartered corporations,
including Fannie Mae and Freddie Mac, or by other corporate guarantors. While
Ginnie Mae's obligations are backed by the full faith and credit of the United
States, the obligations of Fannie Mae and Freddie Mac and other corporate
guarantors are solely their own. As a result, a substantial deterioration in the
financial strength of Fannie Mae, Freddie Mac or other corporate guarantors
could increase our exposure to future delinquencies, defaults or credit losses
on our holdings of Fannie Mae or Freddie Mac-backed mortgage-backed securities
or other corporate-backed mortgage-backed securities, and could harm our results
of operations. In addition, while Freddie Mac guarantees the eventual payment of
principal, it does not guarantee the timely payment thereof, and our results of
operations may be harmed if borrowers are late or delinquent in their payments
on mortgages underlying Freddie Mac-backed mortgage-backed securities. Moreover,
Fannie Mae, Freddie Mac, Ginnie Mae and other corporate guarantees relate only
to payments of limited amounts of principal and interest on the mortgages
underlying such agency-backed or corporate-backed securities, and do not
guarantee the market value of such mortgage-backed securities or the yields on
such mortgage-backed securities. As a result, we remain subject to interest rate
risks, prepayment risks, extension risks and other risks associated with our
investment in such mortgage-backed securities and may experience losses in our
investment portfolio.
WE REMAIN SUBJECT TO LOSSES DESPITE OUR STRATEGY OF INVESTING IN HIGHLY-RATED
MORTGAGE-BACKED SECURITIES.
Our investment guidelines provide that at least 90% of our assets must be
invested in mortgage-backed securities that are either agency-backed or are
rated at least investment grade by at least one rating agency. While
highly-rated mortgage-backed securities are generally subject to a lower risk of
default than lower credit quality mortgage-backed securities and may benefit
from third-party credit enhancements such as insurance or corporate guarantees,
there is no assurance that such mortgage-backed securities will not be subject
to credit losses. Furthermore, ratings are subject to change over time as a
result of a number of factors, including greater than expected delinquencies,
defaults or credit losses, or a deterioration in the financial strength of
corporate guarantors, any of which may reduce the market value of such
securities. Furthermore, ratings do not take into account the reasonableness of
the issue price, interest risks, prepayment risks, extension risks or other
risks associated with such mortgage-backed securities. As a result, while we
attempt to mitigate our exposure to credit risk on a relative basis by focusing
on highly-rated mortgage-backed securities, we cannot eliminate such credit
risks and remain subject to other risks to our investment portfolio and may
suffer losses, which may harm the market price of our common stock.
DECREASES IN THE VALUE OF THE PROPERTY UNDERLYING OUR MORTGAGE-BACKED
SECURITIES MIGHT DECREASE THE VALUE OF OUR ASSETS.
The mortgage-backed securities in which we invest are secured by underlying
real property interests. To the extent that the value of the property underlying
our mortgage-backed securities decreases, our security might be impaired, which
might decrease the value of our assets.
INSURANCE WILL NOT COVER ALL POTENTIAL LOSSES ON THE UNDERLYING REAL PROPERTY
AND THE ABSENCE THEREOF MAY HARM THE VALUE OF OUR ASSETS.
Under our asset acquisition policy, we are permitted to invest up to a
maximum of 10% of our total assets in assets other than mortgage-backed
securities guaranteed by federal agencies or federally chartered entities such
as Fannie Mae, Freddie Mac or Ginnie Mae, or rated as at least investment grade
by a nationally recognized statistical rating agency. Mortgage loans fall
outside of this category of investments under our investment guidelines and are
subject to the 10% limitation. If we elect in the future to purchase mortgage
loans, we may require that each of the mortgage loans that we purchase include
comprehensive insurance covering the underlying real property, including
liability, fire and extended
18
coverage. There are certain types of losses, however, generally of a
catastrophic nature, such as earthquakes, floods and hurricanes, that may be
uninsurable or not economically insurable. Inflation, changes in building codes
and ordinances, environmental considerations, and other factors also might make
it infeasible to use insurance proceeds to replace a property if it is damaged
or destroyed. Under such circumstances, the insurance proceeds, if any, might
not be adequate to restore the economic value of the underlying real property,
which might impair our security and decrease the value of our assets.
DISTRESSED MORTGAGE LOANS HAVE HIGHER RISK OF FUTURE DEFAULT.
If we elect in the future to purchase mortgage loans, we may purchase
distressed mortgage loans as well as mortgage loans that have had a history of
delinquencies. These distressed mortgage loans may be in default or may have a
greater than normal risk of future defaults and delinquencies, as compared to a
pool of newly-originated, high quality loans of comparable type, size and
geographic concentration. Returns on an investment of this type depend on
accurate pricing of such investment, the borrower's ability to make required
payments or, in the event of default, the ability of the loan's servicer to
foreclose and liquidate the mortgage loan. We cannot assure you that the
servicer will be able to liquidate a defaulted mortgage loan in a cost-effective
manner, at an advantageous price or in a timely manner.
SUBORDINATED LOANS ON REAL ESTATE ARE SUBJECT TO HIGHER RISKS.
If we elect in the future to purchase mortgage loans, we may acquire loans
secured by commercial properties, including loans that are subordinate to first
liens on the underlying commercial real estate. Subordinated mortgage loans are
subject to greater risks of loss than first lien mortgage loans. An overall
decline in the real estate market could reduce the value of the real property
securing such loans such that the aggregate outstanding balance of the
second-lien loan and the balance of the more senior loan on the real property
exceed the value of the real property.
WE DEPEND ON OUR KEY PERSONNEL AND THE LOSS OF ANY OF OUR KEY PERSONNEL COULD
SEVERELY AND DETRIMENTALLY AFFECT OUR OPERATIONS.
We depend on the diligence, experience and skill of our officers and the
people working on behalf of our manager for the selection, acquisition,
structuring and monitoring of our mortgage-related assets and associated
borrowings. Our key officers include Gail Seneca, Albert Gutierrez, Christopher
Zyda, Andrew Chow and Troy Grande. We have not entered into employment
agreements with our senior officers other than Mr. Zyda, who is our Senior Vice
President and Chief Financial Officer. With the exception of Mr. Zyda, our
full-time controller and our full-time staff accountant, we do not currently
employ personnel dedicated solely to our business, and our officers (other than
Mr. Zyda) are free to engage in competitive activities in our industry. The loss
of any key person could harm our business, financial condition, cash flow and
results of operations.
RISKS RELATED TO OUR MANAGER
SENECA HAS LIMITED EXPERIENCE MANAGING A REIT AND WE CANNOT ASSURE YOU THAT
SENECA'S PAST EXPERIENCE WILL BE SUFFICIENT TO SUCCESSFULLY MANAGE OUR
BUSINESS AS A REIT.
Seneca Capital Management LLC has limited experience managing a REIT, and
limited experience in complying with the income, asset and other limitations
imposed by the REIT provisions of the Internal Revenue Code. Those provisions
are complex and the failure to comply with those provisions in a timely manner
could prevent us from qualifying as a REIT or could force us to pay unexpected
taxes and penalties. In such event, our net income would be reduced and we could
incur a loss.
OUR MANAGER HAS SIGNIFICANT INFLUENCE OVER OUR AFFAIRS, AND MIGHT CAUSE US TO
ENGAGE IN TRANSACTIONS THAT ARE NOT IN OUR OR OUR STOCKHOLDERS' BEST
INTERESTS.
In addition to managing us and having at least two of its designees as
members of our board, Seneca provides advice on our operating policies and
strategies. Seneca may also cause us to engage in future
19
transactions with Seneca and its affiliates, subject to the approval of, or
guidelines approved by, the independent members of our board of directors. Our
directors, however, rely primarily on information supplied by our manager in
reaching their determinations. Accordingly, our manager has significant
influence over our affairs, and may cause us to engage in transactions which are
not in our best interest.
OUR MANAGER AND ITS AFFILIATES MIGHT ALLOCATE MORTGAGE-RELATED OPPORTUNITIES
TO OTHER ENTITIES, AND THUS MIGHT DIVERT ATTRACTIVE INVESTMENT OPPORTUNITIES
AWAY FROM US.
Our operations and assets are managed by specified individuals at Seneca.
Seneca and its affiliates, including some of our officers, manage portfolios for
parties unrelated to us. These multiple responsibilities might create conflicts
of interest for Seneca and these individuals if they are presented with
opportunities that might benefit us and their other clients. Seneca and these
individuals must allocate investments among our portfolio and their other
clients by determining the entity or account for which the investment is most
suitable. In making this determination, Seneca and these individuals consider
the investment strategy and guidelines of each entity or account with respect to
acquisition of assets, leverage, liquidity and other factors that Seneca and
these individuals determine appropriate. However, Seneca and those working on
its behalf have no obligation to make any specific investment opportunities
available to us and the above-mentioned conflicts of interest might result in
decisions or allocations of investments that are not in our or our stockholders'
best interests.
WE WILL PAY SENECA INCENTIVE COMPENSATION BASED ON OUR PORTFOLIO'S
PERFORMANCE. THIS ARRANGEMENT MAY LEAD SENECA TO RECOMMEND RISKIER OR MORE
SPECULATIVE INVESTMENTS IN AN EFFORT TO MAXIMIZE ITS INCENTIVE COMPENSATION.
In addition to its base management fee, Seneca earns incentive compensation
for each fiscal quarter equal to a specified percentage of the amount by which
our return on equity, before deducting incentive compensation, exceeds a return
based on the 10-year U.S. Treasury rate plus 2%. The percentage for this
calculation is the weighted-average of the following percentages based on our
average net invested assets for the period:
- 20% for the first $400 million of our average net invested assets; and
- 10% of our average net invested assets in excess of $400 million.
Pursuant to the formula for calculating Seneca's incentive compensation,
Seneca shares in our profits but not in our losses. Consequently, as Seneca
evaluates different mortgage-backed securities and other investments for our
account, there is a risk that Seneca will cause us to assume more risk than is
prudent in an attempt to increase its incentive compensation. Other key criteria
related to determining appropriate investments and investment strategies,
including the preservation of capital, might be under-weighted if Seneca focuses
exclusively or disproportionately on maximizing its income.
WE MAY BE OBLIGATED TO PAY SENECA INCENTIVE COMPENSATION EVEN IF WE INCUR A
LOSS.
Pursuant to the management agreement, Seneca is entitled to receive
incentive compensation for each fiscal quarter in an amount equal to a tiered
percentage of the excess of our taxable income for that quarter (before
deducting incentive compensation, net operating losses and certain other items)
above a threshold return for that quarter. In addition, the management agreement
further provides that our taxable income for incentive compensation purposes
excludes net capital losses that we may incur in the fiscal quarter, even if
such capital losses result in a net loss on our statement of operations for that
quarter. Thus, we may be required to pay Seneca incentive compensation for a
fiscal quarter even if there is a decline in the value of our portfolio or we
incur a net loss for that quarter.
20
DURING PERIODS OF DECLINING MARKET PRICES FOR SHARES OF OUR COMMON STOCK, WE
MAY BE REQUIRED TO ISSUE GREATER NUMBERS OF SHARES TO SENECA FOR THE SAME
AMOUNT OF INCENTIVE COMPENSATION ARISING UNDER THE MANAGEMENT AGREEMENT, WHICH
WILL HAVE A DILUTIVE EFFECT ON OUR STOCKHOLDERS THAT MAY HARM THE MARKET PRICE
OF OUR COMMON STOCK.
Pursuant to the terms of the management agreement, the incentive
compensation payable to Seneca for each fiscal quarter is paid one-half in cash
and one-half in restricted shares of our common stock. The number of shares to
be issued to Seneca is based on (a) one-half of the total incentive compensation
for the period, divided by (b) the average of the closing prices of the common
stock over the 30 day period ending three days prior to the grant date, less a
fair market value discount determined by our board of directors. During periods
of declining market prices for shares of our common stock, we may be required to
issue more shares to Seneca for the same amount of incentive compensation.
Although these shares will initially be subject to restrictions on transfer
which lapse ratably over a three-year period, the issuance of these shares will
have a dilutive effect on our stockholders which may harm the market price of
our common stock.
BECAUSE SENECA MIGHT RECEIVE A SIGNIFICANT FEE IF WE TERMINATE THE MANAGEMENT
AGREEMENT, ECONOMIC CONSIDERATIONS MIGHT PRECLUDE US FROM TERMINATING THE
MANAGEMENT AGREEMENT IN THE EVENT THAT SENECA FAILS TO MEET OUR EXPECTATIONS.
If we terminate the management agreement without cause or because we decide
to manage our company internally or if Seneca terminates the management in the
event of a change of control, then we will have to pay a significant fee to
Seneca. The amount of the fee depends on whether:
- we terminate the management agreement without cause in connection with a
decision to manage our portfolio internally, in which case we will be
obligated to pay to Seneca a fee equal to the highest amount of
management fees incurred in a particular year during the then three most
recent years; or
- our decision to terminate the management agreement without cause is for a
reason other than our decision to manage our portfolio internally, in
which case we will be obligated to pay Seneca an amount equal to two
times the highest amount of management fees incurred in a particular year
during the then three most recent years.
In each of the above cases, Seneca will also receive accelerated vesting of
the equity component of its incentive compensation. The actual amount of such
fee cannot be known at this time because it is based in part on the performance
of our portfolio of mortgage-backed securities. Paying this fee would reduce
significantly the cash available for distribution to our stockholders and might
cause us to suffer a net operating loss. Consequently, terminating the
management agreement might not be advisable even if we determine that it would
be more efficient to operate with an internal management structure or if we are
otherwise dissatisfied with Seneca's performance.
INVESTORS MAY NOT BE ABLE TO ESTIMATE WITH CERTAINTY THE AGGREGATE FEES AND
EXPENSE REIMBURSEMENTS THAT WILL BE PAID TO SENECA UNDER THE MANAGEMENT
AGREEMENT AND THE COST-SHARING AGREEMENT DUE TO THE TIME AND MANNER IN WHICH
SENECA'S INCENTIVE COMPENSATION AND EXPENSE REIMBURSEMENTS ARE DETERMINED.
Seneca may be entitled to substantial fees pursuant to the management
agreement. Seneca's base management fee is calculated as a percentage of our
average net worth. Seneca's incentive compensation is calculated as a tiered
percentage of our taxable income (before deducting certain items) in excess of a
threshold amount of taxable income and is indeterminable in advance of a
particular period. Since future payments of base management fees, incentive
compensation and expense reimbursements are determined at future dates based
upon our then-applicable average net worth, results of operations and actual
expenses incurred by Seneca, such fees and expense reimbursements cannot be
estimated with mathematical certainty. Any base management fees, incentive
compensation or expense reimbursements payable to Seneca may be materially
greater or less than the historical amounts and we can provide no assurance at
21
this time as to the amount of any such base management fee, incentive
compensation or expense reimbursements that may be payable to Seneca in the
future.
SENECA MAY RENDER SERVICES TO OTHER MORTGAGE INVESTORS, WHICH COULD REDUCE THE
AMOUNT OF TIME AND EFFORT THAT SENECA DEVOTES TO US.
Our management agreement with Seneca does not restrict the right of Seneca,
any persons working on its behalf or any of its affiliates, to carry on their
respective businesses, including the rendering of advice to others regarding the
purchase of mortgage-backed securities that would meet our investment criteria.
In addition, the management agreement does not specify a minimum time period
that Seneca and its personnel must devote to managing our investments. The
ability of Seneca to engage in these other business activities, and specifically
to manage mortgage-related assets for third parties, could reduce the time and
effort it spends managing our portfolio to the detriment of our investment
returns.
SENECA'S LIABILITY IS LIMITED UNDER THE MANAGEMENT AGREEMENT, AND WE HAVE
AGREED TO INDEMNIFY SENECA AGAINST CERTAIN LIABILITIES.
Seneca has not assumed any responsibility to us other than to render the
services described in the management agreement, and will not be responsible for
any action of our board of directors in declining to follow Seneca's advice or
recommendations. Seneca and its directors, officers and employees will not be
liable to us for acts performed by its officers, directors, or employees in
accordance with and pursuant to the management agreement, except for acts
constituting gross negligence, recklessness, willful misconduct or active fraud
in connection with their duties under the management agreement. We have agreed
to indemnify Seneca and its directors, officers and employees with respect to
all expenses, losses, damages, liabilities, demands, charges and claims arising
from acts of Seneca not constituting gross negligence, recklessness, willful
misconduct or active fraud.
LEGAL AND TAX RISKS
IF WE ARE DISQUALIFIED AS A REIT, WE WILL BE SUBJECT TO TAX AS A REGULAR
CORPORATION AND FACE SUBSTANTIAL TAX LIABILITY.
Qualification as a REIT involves the application of highly technical and
complex U.S. federal income tax code provisions for which only a limited number
of judicial or administrative interpretations exist. Accordingly, it is not
certain we will be able to become and remain qualified as a REIT for U.S.
federal income tax purposes. Even a technical or inadvertent mistake could
jeopardize our REIT status. Furthermore, Congress or the Internal Revenue
Service, or IRS, might change tax laws or regulations and the courts might issue
new rulings, in each case potentially having retroactive effect, that could make
it more difficult or impossible for us to qualify as a REIT. If we fail to
qualify as a REIT in any tax year, then:
- we would be taxed as a regular domestic corporation, which, among other
things, means that we would be unable to deduct distributions to
stockholders in computing taxable income and we would be subject to U.S.
federal income tax on our taxable income at regular corporate rates;
- any resulting tax liability could be substantial, would reduce the amount
of cash available for distribution to stockholders, and could force us to
liquidate assets at inopportune times, causing lower income or higher
losses than would result if these assets were not liquidated; and
- unless we were entitled to relief under applicable statutory provisions,
we would be disqualified from treatment as a REIT for the subsequent four
taxable years following the year during which we lost our qualification
and, thus, our cash available for distribution to our stockholders would
be reduced for each of the years during which we did not qualify as a
REIT.
Even if we remain qualified as a REIT, we might face other tax liabilities
that reduce our cash flow. Further, we might be subject to federal, state and
local taxes on our income and property. Any of these taxes would decrease cash
available for distribution to our stockholders.
22
COMPLYING WITH REIT REQUIREMENTS MIGHT CAUSE US TO FOREGO OTHERWISE ATTRACTIVE
OPPORTUNITIES.
In order to qualify as a REIT for U.S. federal income tax purposes, we must
satisfy tests concerning, among other things, our sources of income, the nature
and diversification of our mortgage-backed securities, the amounts we distribute
to our stockholders and the ownership of our stock. We may also be required to
make distributions to our stockholders at disadvantageous times or when we do
not have funds readily available for distribution. Thus, compliance with REIT
requirements may cause us to forego opportunities we would otherwise pursue.
In addition, the REIT provisions of the Internal Revenue Code impose a 100%
tax on income from "prohibited transactions." Prohibited transactions generally
include sales of assets that constitute inventory or other property held for
sale in the ordinary course of a business, other than foreclosure property. This
100% tax could impact our desire to sell mortgage-backed securities at otherwise
opportune times if we believe such sales could be considered a prohibited
transaction.
COMPLYING WITH REIT REQUIREMENTS MAY LIMIT OUR ABILITY TO HEDGE EFFECTIVELY.
The existing REIT provisions of the Internal Revenue Code substantially
limit our ability to hedge mortgage-backed securities and related borrowings.
Under these provisions, our annual income from qualified hedges, together with
any other income not generated from qualified REIT real estate assets, is
limited to less than 25% of our gross income. In addition, we must limit our
aggregate income from hedging and services from all sources, other than from
qualified REIT real estate assets or qualified hedges, to less than 5% of our
annual gross income. As a result, we might in the future have to limit our use
of advantageous hedging techniques. This could leave us exposed to greater risks
associated with changes in interest rates than we would otherwise want to bear.
If we were to violate the 25% or 5% limitations, we might have to pay a penalty
tax equal to the amount of our income in excess of those limitations, multiplied
by a fraction intended to reflect our profitability. If we fail to satisfy the
25% or 5% limitations, unless our failure was due to reasonable cause and not
due to willful neglect, we could lose our REIT status for federal income tax
purposes.
COMPLYING WITH REIT REQUIREMENTS MAY FORCE US TO LIQUIDATE OTHERWISE
ATTRACTIVE INVESTMENTS.
In order to qualify as a REIT, we must ensure that at the end of each
calendar quarter at least 75% of the value of our assets consists of cash, cash
items, government securities and qualified REIT real estate assets. The
remainder of our investment in securities generally cannot include more than 10%
of the outstanding voting securities of any one issuer or more than 10% of the
total value of the outstanding securities of any one issuer. In addition,
generally, no more than 5% of the value of our assets can consist of the
securities of any one issuer. If we fail to comply with these requirements, we
must dispose of a portion of our assets within 30 days after the end of the
calendar quarter in order to avoid losing our REIT status and suffering adverse
tax consequences.
COMPLYING WITH REIT REQUIREMENTS MAY FORCE US TO BORROW TO MAKE DISTRIBUTIONS
TO OUR STOCKHOLDERS.
As a REIT, we must distribute 90% of our annual taxable income (subject to
certain adjustments) to our stockholders. From time to time, we might generate
taxable income greater than our net income for financial reporting purposes
from, among other things, amortization of capitalized purchase premiums, or our
taxable income might be greater than our cash flow available for distribution to
our stockholders. If we do not have other funds available in these situations,
we might be unable to distribute 90% of our taxable income as required by the
REIT rules. In that case, we would need to borrow funds, sell a portion of our
mortgage-backed securities potentially at disadvantageous prices or find another
alternative source of funds. These alternatives could increase our costs or
reduce our equity and reduce amounts available to invest in mortgage-backed
securities.
23
FAILURE TO MAINTAIN AN EXEMPTION FROM THE INVESTMENT COMPANY ACT WOULD HARM
OUR RESULTS OF OPERATIONS.
We intend to conduct our business so as not to become regulated as an
investment company under the Investment Company Act of 1940, as amended. If we
fail to qualify for this exemption, our ability to use leverage would be
substantially reduced and we would be unable to conduct our business as
described in this prospectus.
The Investment Company Act exempts entities that are primarily engaged in
the business of purchasing or otherwise acquiring mortgages and other liens on,
and interests in, real estate. Under the current interpretation of the SEC
staff, in order to qualify for this exemption, we must maintain at least 55% of
our assets directly in these qualifying real estate interests. Mortgage-backed
securities that do not represent all of the certificates issued with respect to
an underlying pool of mortgages may be treated as separate from the underlying
mortgage loans and, thus, may not qualify for purposes of the 55% requirement.
Therefore, our ownership of these mortgage-backed securities is limited by the
provisions of the Investment Company Act.
In satisfying the 55% requirement under the Investment Company Act, we
treat as qualifying interests mortgage-backed securities issued with respect to
an underlying pool as to which we hold all issued certificates. If the SEC or
its staff adopts a contrary interpretation of such treatment, we could be
required to sell a substantial amount of our mortgage-backed securities under
potentially adverse market conditions. Further, in our attempts to ensure that
we at all times qualify for the exemption under the Investment Company Act, we
might be precluded from acquiring mortgage-backed securities if their yield is
higher than the yield on mortgage-backed securities that could be purchased in a
manner consistent with the exemption. These factors may lower or eliminate our
net income.
MISPLACED RELIANCE ON LEGAL OPINIONS OR STATEMENTS BY ISSUERS OF
MORTGAGE-BACKED SECURITIES COULD RESULT IN A FAILURE TO COMPLY WITH REIT
INCOME OR ASSETS TESTS.
When purchasing mortgage-backed securities, we may rely on opinions of
counsel for the issuer or sponsor of such securities, or statements made in
related offering documents, for purposes of determining whether and to what
extent those securities constitute REIT real estate assets for purposes of the
REIT asset tests and produce income that qualifies under the REIT gross income
tests. The inaccuracy of any such opinions or statements may adversely affect
our REIT qualification and result in significant corporate-level tax.
ONE-ACTION RULES MAY HARM THE VALUE OF THE UNDERLYING PROPERTY.
Several states have laws that prohibit more than one action to enforce a
mortgage obligation, and some courts have construed the term "action" broadly.
In such jurisdictions, if the judicial action is not conducted according to law,
there may be no other recourse in enforcing a mortgage obligation, thereby
decreasing the value of the underlying property.
WE MAY BE HARMED BY CHANGES IN VARIOUS LAWS AND REGULATIONS.
Changes in the laws or regulations governing Seneca or its affiliates may
impair Seneca's or its affiliates' ability to perform services in accordance
with the management agreement. Our business may be harmed by changes to the laws
and regulations affecting our manager or us, including changes to securities
laws and changes to the Internal Revenue Code applicable to the taxation of
REITs. New legislation may be enacted into law or new interpretations, rulings
or regulations could be adopted, any of which could harm us, our manager and our
stockholders, potentially with retroactive effect.
Legislation was recently enacted that reduces the maximum tax rate of
non-corporate taxpayers for capital gains (for taxable years ending on or after
May 6, 2003 and before January 1, 2009) and for dividends (for taxable years
beginning after December 31, 2002 and before January 1, 2009) to 15%. Generally,
dividends paid by REITs are not eligible for the new 15% federal income tax
rate, with certain
24
exceptions discussed at "United States Federal Income Tax Considerations --
Taxation of Taxable United States Stockholders -- Distributions Generally."
Although this legislation does not adversely affect the taxation of REITs or
dividends paid by REITs, the more favorable treatment of regular corporate
dividends could cause investors who are individuals to consider stocks of other
corporations that pay dividends as more attractive relative to stocks of REITs.
It is not possible to predict whether this change in perceived relative value
will occur, or what the effect will be on the market price of our common stock.
In addition, legislation was recently introduced in the United States House
of Representatives and the United States Senate that would amend certain rules
relating to REITs. Among other changes, the proposed legislation would provide
the Internal Revenue Service with the ability to impose monetary penalties,
rather than a loss of REIT status, for reasonable cause violations of certain
tests relating to REIT qualification, and would change the formula for
calculating the tax imposed for certain violations of the income tests discussed
at "United States Federal Income Tax Considerations -- Requirements for
Qualification as a REIT -- Income Tests." In general, the changes would apply to
taxable years beginning after the date the legislation is enacted. As of the
date hereof, it is not possible to predict with any certainty whether the
proposed legislation will be enacted in its current form.
WE MAY INCUR EXCESS INCLUSION INCOME THAT WOULD INCREASE THE TAX LIABILITY OF
OUR STOCKHOLDERS.
In general, dividend income that a tax-exempt entity receives from us
should not constitute unrelated business taxable income as defined in Section
512 of the Internal Revenue Code. If we realize excess inclusion income and
allocate it to stockholders, this income cannot be offset by net operating
losses. If the stockholder is a tax-exempt entity, then this income would be
fully taxable as unrelated business taxable income under Section 512 of the
Internal Revenue Code. If the stockholder is foreign, it would be subject to
U.S. federal income tax withholding on this income without reduction pursuant to
any otherwise applicable income-tax treaty.
Excess inclusion income could result if we held a residual interest in a
real estate mortgage investment conduit, or REMIC. Excess inclusion income also
would be generated if we were to issue debt obligations with two or more
maturities and the terms of the payments on these obligations bore a
relationship to the payments that we received on our mortgage-backed securities
securing those debt obligations. We generally structure our borrowing
arrangements in a manner designed to avoid generating significant amounts of
excess inclusion income. We do, however, enter into various repurchase
agreements that have differing maturity dates and afford the lender the right to
sell any pledged mortgage securities if we default on our obligations. The IRS
may determine that these borrowings give rise to excess inclusion income that
should be allocated among stockholders. Furthermore, some types of tax-exempt
entities, including voluntary employee benefit associations and entities that
have borrowed funds to acquire their shares of our common stock, may be required
to treat a portion of or all of the dividends they may receive from us as
unrelated business taxable income. Finally, we may invest in equity securities
of other REITs and it is possible that we might receive excess inclusion income
from those investments.
RISKS RELATED TO THIS OFFERING
WE HAVE NOT ESTABLISHED A MINIMUM DISTRIBUTION PAYMENT LEVEL AND WE CANNOT
ASSURE YOU OF OUR ABILITY TO MAKE DISTRIBUTIONS TO OUR STOCKHOLDERS IN THE
FUTURE.
We intend to make quarterly distributions to our stockholders in amounts
such that we distribute all or substantially all of our taxable income in each
year, subject to certain adjustments. This, along with other factors, should
enable us to qualify for the tax benefits accorded to a REIT under the Internal
Revenue Code. We have not established a minimum distribution payment level and
our ability to make distributions might be harmed by the risk factors described
in this prospectus. All distributions will be made at the discretion of our
board of directors and will depend on our earnings, our financial condition,
maintenance of our REIT status and such other factors as our board of directors
may deem relevant from time to time. We cannot assure you that we will have the
ability to make distributions to our stockholders in the future.
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OUR ABILITY TO PAY OUR DECLARED CASH DISTRIBUTION FOR THE FIRST QUARTER OF
2004 DEPENDS UPON OUR ACTUAL OPERATING RESULTS FOR THE QUARTER. IF OUR ACTUAL
RESULTS ARE BELOW OUR EXPECTATIONS, WE WILL NEED TO SELL ASSETS OR BORROW
FUNDS TO PAY THE DISTRIBUTION.
On March 9, 2004 our board of directors declared a cash distribution of
$0.42 per share for the first quarter of 2004, payable on April 26, 2004 to
stockholders of record on March 19, 2004. This offering will close after the
distribution record date and, accordingly, purchasers of common stock in this
offering will not receive the distribution.
This distribution declaration for the first quarter 2004 is irrevocable and
is not contingent on our operating performance. If we do not generate sufficient
cash flow from ongoing operations (including principal payments and interest
payments on our mortgage-backed securities) to fund the distribution, we will
need to sell mortgage-backed securities or borrow funds by entering into
repurchase agreements or otherwise borrowing funds under our line of credit to
pay the distribution. If we were to borrow funds on a regular basis to make
distributions in excess of operating cash flow, it is likely that our results of
operations and our stock price would be harmed.
RESTRICTIONS ON OWNERSHIP OF A CONTROLLING PERCENTAGE OF OUR CAPITAL STOCK
MIGHT LIMIT YOUR OPPORTUNITY TO RECEIVE A PREMIUM ON OUR STOCK.
For the purpose of preserving our REIT qualification and for other reasons,
our charter prohibits direct or constructive ownership by any person of more
than 9.8% of the lesser of the total number or value of the outstanding shares
of our common stock or more than 9.8% of the outstanding shares of our preferred
stock. The constructive ownership rules in our charter are complex and may cause
the outstanding stock owned by a group of related individuals or entities to be
deemed to be constructively owned by one individual or entity. As a result, the
acquisition of less than 9.8% of the outstanding stock by an individual or
entity could cause that individual or entity to own constructively in excess of
9.8% of the outstanding stock, and thus be subject to the ownership limit in our
charter. Any attempt to own or transfer shares of our common or preferred stock
in excess of the ownership limit without the consent of our board of directors
shall be void, and will result in the shares being transferred by operation of
law to a charitable trust. These provisions might inhibit market activity and
the resulting opportunity for our stockholders to receive a premium for their
shares that might otherwise exist if any person were to attempt to assemble a
block of shares of our stock in excess of the number of shares permitted under
our charter and which may be in the best interests of our stockholders.
CERTAIN PROVISIONS OF MARYLAND LAW AND OUR CHARTER AND BYLAWS COULD HINDER,
DELAY OR PREVENT A CHANGE IN CONTROL OF OUR COMPANY.
Certain provisions of Maryland law, our charter and our bylaws have the
effect of discouraging, delaying or preventing transactions that involve an
actual or threatened change in control of our company. These provisions include
the following:
- Classified Board of Directors. Our board of directors is divided into
three classes with staggered terms of office of three years each. The
classification and staggered terms of office of our directors make it
more difficult for a third party to gain control of our board of
directors. At least two annual meetings of stockholders, instead of one,
generally would be required to effect a change in a majority of the board
of directors.
- Removal of Directors. Under our charter, subject to the rights of one or
more classes or series of preferred stock to elect one or more directors,
a director may be removed only for cause and only by the affirmative vote
of at least two-thirds of all votes entitled to be cast by our
stockholders generally in the election of directors.
- Number of Directors, Board Vacancies, Term of Office. We have elected to
be subject to certain provisions of Maryland law which vest in the board
of directors the exclusive right to determine the number of directors and
the exclusive right, by the affirmative vote of a majority of the
remaining
26
directors, to fill vacancies on the board even if the remaining directors
do not constitute a quorum. These provisions of Maryland law, which are
applicable even if other provisions of Maryland law or the charter or
bylaws provide to the contrary, also provide that any director elected to
fill a vacancy shall hold office for the remainder of the full term of
the class of directors in which the vacancy occurred, rather than the
next annual meeting of stockholders as would otherwise be the case, and
until his or her successor is elected and qualifies.
- Limitation on Stockholder-Requested Special Meetings. Our bylaws provide
that our stockholders have the right to call a special meeting only upon
the written request of stockholders entitled to cast not less than a
majority of all the votes entitled to be cast by the stockholders at such
meeting.
- Advance Notice Provisions for Stockholder Nominations and Proposals. Our
bylaws require advance written notice for stockholders to nominate
persons for election as directors at, or to bring other business before,
any meeting of stockholders. This bylaw provision limits the ability of
stockholders to make nominations of persons for election as directors or
to introduce other proposals unless we are notified in a timely manner
prior to the meeting.
- Exclusive Authority of our Board to Amend the Bylaws. Our bylaws provide
that our board of directors has the exclusive power to adopt, alter or
repeal any provision of the bylaws or to make new bylaws. Thus, our
stockholders may not effect any changes to our bylaws.
- Preferred Stock. Under our charter, our board of directors has authority
to issue preferred stock from time to time in one or more series and to
establish the terms, preferences and rights of any such series of
preferred stock, all without approval of our stockholders.
- Duties of Directors with Respect to Unsolicited Takeovers. Maryland law
provides protection for Maryland corporations against unsolicited
takeovers by limiting, among other things, the duties of the directors in
unsolicited takeover situations. The duties of directors of Maryland
corporations do not require them to (1) accept, recommend or respond to
any proposal by a person seeking to acquire control of the corporation,
(2) authorize the corporation to redeem any rights under, or modify or
render inapplicable, any stockholders rights plan, (3) make a
determination under the Maryland Business Combination Act or the Maryland
Control Share Acquisition Act, or (4) act or fail to act solely because
of the effect of the act or failure to act may have on an acquisition or
potential acquisition of control of the corporation or the amount or type
of consideration that may be offered or paid to the stockholders in an
acquisition. Moreover, under Maryland law the act of the directors of a
Maryland corporation relating to or affecting an acquisition or potential
acquisition of control is not subject to any higher duty or greater
scrutiny than is applied to any other act of a director. Maryland law
also contains a statutory presumption that an act of a director of a
Maryland corporation satisfies the applicable standards of conduct for
directors under Maryland law.
- Ownership Limit. In order to preserve our status as a REIT under the
Internal Revenue Code, our charter generally permits any single
stockholder, or any group of affiliated stockholders, from beneficially
owning more than 9.8% of our outstanding common or preferred stock unless
our board of directors waives or modifies this ownership limit.
- Maryland Business Combination Act. The Maryland Business Combination Act
provides that unless exempted, a Maryland corporation may not engage in
business combinations, including mergers, dispositions of 10% or more of
its assets, certain issuances of shares of stock and other specified
transactions, with an "interested stockholder" or an affiliate of an
interested stockholder for five years after the most recent date on which
the interested stockholder became an interested stockholder, and
thereafter unless specified criteria are met. An interested stockholder
is generally a person owning or controlling, directly or indirectly, 10%
or more of the voting power of the outstanding stock of a Maryland
corporation. Our board of directors has adopted a resolution exempting
our company from this statute. However, our board of directors may repeal
or modify
27
this resolution in the future, in which case the provisions of the
Maryland Business Combination Act will be applicable to business
combinations between our company and other persons.
- Maryland Control Share Acquisition Act. Maryland law provides that
"control shares" of a corporation acquired in a "control share
acquisition" shall have no voting rights except to the extent approved by
a vote of two-thirds of the votes eligible to be cast on the matter under
the Maryland Control Share Acquisition Act. "Control shares" means shares
of stock that, if aggregated with all other shares of stock previously
acquired by the acquiror, would entitle the acquiror to exercise voting
power in electing directors within one of the following ranges of the
voting power: one-tenth or more but less than one-third, one-third or
more but less than a majority or a majority or more of all voting power.
A "control share acquisition" means the acquisition of control shares,
subject to certain exceptions. If voting rights of control shares
acquired in a control share acquisition are not approved at a
stockholders' meeting, then subject to certain conditions and
limitations, the issuer may redeem any or all of the control shares for
fair value. If voting rights of such control shares are approved at a
stockholders' meeting and the acquiror becomes entitled to vote a
majority of the shares of stock entitled to vote, all other stockholders
may exercise appraisal rights. Our bylaws contain a provision exempting
acquisitions of our shares from the Maryland Control Share Acquisition
Act. However, our board of directors may amend our bylaws in the future
to repeal or modify this exemption, in which case any control shares of
our company acquired in a control share acquisition will be subject to
the Maryland Control Share Acquisition Act.
FUTURE OFFERINGS OF DEBT SECURITIES, WHICH WOULD BE SENIOR TO OUR COMMON STOCK
UPON LIQUIDATION, OR EQUITY SECURITIES, WHICH WOULD DILUTE OUR EXISTING
STOCKHOLDERS AND MAY BE SENIOR TO OUR COMMON STOCK FOR THE PURPOSES OF
DISTRIBUTIONS, MAY HARM THE VALUE OF OUR COMMON STOCK.
In the future, we may attempt to increase our capital resources by making
additional offerings of debt or equity securities, including commercial paper,
medium-term notes, senior or subordinated notes and classes of preferred stock
or common stock. Upon the liquidation of our company, holders of our debt
securities and shares of preferred stock and lenders with respect to other
borrowings will receive a distribution of our available assets prior to the
holders of our common stock. Additional equity offerings by us may dilute the
holdings of our existing stockholders or reduce the value of our common stock,
or both. Our preferred stock, if issued, would have a preference on
distributions that could limit our ability to make distributions to the holders
of our common stock. Because our decision to issue securities in any future
offering will depend on market conditions and other factors beyond our control,
we cannot predict or estimate the amount, timing or nature of our future
offerings. Thus, our stockholders bear the risk of our future offerings reducing
the market price of our common stock and diluting their stock holdings in us.
THE MARKET PRICE AND TRADING VOLUME OF OUR COMMON STOCK MAY BE VOLATILE.
Even if an active trading market develops for our common stock after this
offering, the market price of our common stock may be highly volatile and be
subject to wide fluctuations. In addition, the trading volume in our common
stock may fluctuate and cause significant price variations to occur. If the
market price of our common stock declines significantly, you may be unable to
resell your shares at or above your purchase price. We cannot assure you that
the market price of our common stock will not fluctuate or decline significantly
in the future. Some of the factors that could negatively affect our stock price
or result in fluctuations in the price or trading volume of our common stock
include:
- actual or anticipated variations in our quarterly operating results or
distributions;
- changes in our funds from operations or earnings estimates or publication
of research reports about us or the real estate industry, although there
can be no assurance that any research reports about us will be published;
- increases in market interest rates that lead purchasers of our shares to
demand a higher yield;
- changes in market valuations of similar companies;
28
- adverse market reaction to any increased indebtedness we incur in the
future;
- additions or departures of key management personnel;
- actions by institutional stockholders;
- speculation in the press or investment community; and
- general market and economic conditions.
BROAD MARKET FLUCTUATIONS COULD HARM THE MARKET PRICE OF OUR COMMON STOCK.
The stock market has experienced extreme price and volume fluctuations that
have affected the market price of many companies in industries similar or
related to ours and that have been unrelated to these companies' operating
performances. These broad market fluctuations could reduce the market price of
our common stock. Furthermore, our operating results and prospects may be below
the expectations of public market analysts and investors or may be lower than
those of companies with comparable market capitalizations, which could harm the
market price of our common stock.
SHARES OF OUR COMMON STOCK ELIGIBLE FOR FUTURE SALE MAY HARM OUR STOCK PRICE.
We cannot predict the effect, if any, of future sales of shares of our
common stock, or the availability of shares for future sales, on the market
price of our common stock. Sales of substantial amounts of these shares of
common stock, or the perception that these sales could occur, may harm
prevailing market prices for our common stock. As of March 29, 2004, there are:
- 24,841,146 shares of outstanding common stock;
- outstanding options to purchase 55,000 shares of our common stock at a
weighted-average exercise price of $14.82 per share; and
- an additional 943,505 shares of our common stock available for future
awards under our stock incentive plans.
A total of 943,505 shares of our common stock, or 1% of our current total
authorized shares, are reserved for future awards and grants under our stock
incentive plans. We recently filed a registration statement on Form S-8 under
the Securities Act covering the 1.0 million shares of our common stock issued or
reserved for issuance under our stock incentive plans and/or subject to
outstanding options under our stock incentive plans. Shares of our common stock
issued upon exercise of options under the Form S-8 will be available for sale in
the public market, subject to Rule 144 volume limitations applicable to
affiliates and subject to the contractual restrictions described above.
We recently issued 13,110,000 shares of common stock in our initial public
offering. All of those shares are eligible for immediate resale by their
holders. Additionally, we recently filed a registration statement covering the
resale of up to 11,500,000 shares of our common stock by the selling
stockholders named in the prospectus which is a part of such resale registration
statement. All of the shares sold from time to time pursuant to our resale
registration statement will be eligible for immediate resale by their holders.
If any or all of the above holders sell a large number of securities in the
public market, the sale could reduce the market price of our common stock and
could impede our ability to raise future capital through a sale of additional
equity securities.
CHANGES IN YIELDS MAY HARM THE MARKET PRICE OF OUR STOCK.
Our earnings are derived primarily from the expected positive spread
between the yield on our assets and the cost of our borrowings. This spread will
not necessarily be larger in high interest rate environments than in low
interest rate environments and may also be negative. In addition, during periods
of high interest rates, our net income, and therefore the amount of any
distributions on our common stock, might
29
be less attractive compared to alternative investments of equal or lower risk.
Each of these factors could harm the market price of our common stock.
TERRORIST ATTACKS AND OTHER ACTS OF VIOLENCE OR WAR MAY AFFECT ANY MARKET FOR
OUR COMMON STOCK, THE INDUSTRY IN WHICH WE OPERATE, OUR OPERATIONS AND OUR
PROFITABILITY.
Terrorist attacks may harm our results of operations and your investment.
We cannot assure you that there will not be further terrorist attacks against
the United States or U.S. businesses. These attacks or armed conflicts may
impact the property underlying our mortgage-backed securities directly or
indirectly, by undermining economic conditions in the United States. Losses
resulting from terrorist events are generally uninsurable.
30
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This prospectus contains certain forward-looking statements. Forward
looking statements are those which are not historical in nature. They can often
be identified by their inclusion of words such as "will," "anticipate,"
"estimate," "should," "expect," "believe," "intend" and similar expressions. Any
projection of revenues, earnings or losses, capital expenditures, distributions,
capital structure or other financial terms is a forward-looking statement.
Our forward-looking statements are based upon our management's beliefs,
assumptions and expectations of our future operations and economic performance,
taking into account the information currently available to us. Forward-looking
statements involve risks and uncertainties, some of which are not currently
known to us, that might cause our actual results, performance or financial
condition to be materially different from the expectations of future results,
performance or financial condition we express or imply in any forward-looking
statements. Some of the important factors that could cause our actual results,
performance or financial condition to differ materially from expectations are:
- our limited operating history and Seneca's limited experience in managing
a REIT;
- your inability to review the assets that we will acquire with the net
proceeds of this offering;
- interest rate mismatches between our mortgage-backed securities and our
borrowings used to fund such purchases;
- changes in interest rates and mortgage prepayment rates;
- effects of interest rate caps on our adjustable-rate mortgage-backed
securities;
- the degree to which our hedging strategies may or may not protect us from
interest rate volatility;
- potential impacts of our leveraging policies on our net income and cash
available for distribution;
- our ability to invest up to 10% of our investment portfolio in
lower-credit quality mortgage-backed securities which carry an increased
likelihood of default or rating downgrade relative to investment-grade
securities;
- our board's ability to change our operating policies and strategies
without notice to you or stockholder approval;
- Seneca's motivation to recommend riskier investments in an effort to
maximize its incentive compensation under the management agreement;
- potential conflicts of interest arising out of our relationship with
Seneca, on the one hand, and Seneca's relation with other third parties,
on the other hand; and
- the other important factors described in this prospectus, including under
the captions "Risk Factors," "Management's Discussion and Analysis of
Financial Condition and Results of Operations," and "Quantitative and
Qualitative Disclosures about Market Risk."
We undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
In light of these risks, uncertainties and assumptions, the events described by
our forward-looking events might not occur. We qualify any and all of our
forward-looking statements by these cautionary factors. Please keep this
cautionary note in mind as you read this prospectus.
This prospectus contains market data, industry statistics and other data
that have been obtained from, or compiled from, information made available by
third parties. We have not independently verified their data.
31
USE OF PROCEEDS
We estimate that the net proceeds that we receive in this offering will be
approximately $157.5 million, based on the public offering price of $14.00 per
share and after deducting the underwriting discount and estimated offering
expenses of $10.5 million payable by us. If the underwriters' over-allotment
option is exercised in full, we estimate that our net proceeds will be
approximately $181.2 million.
We intend to use the net proceeds of this offering received by us to expand
our portfolio of mortgage-related assets, primarily U.S. agency and other
highly-rated, single-family, adjustable-rate, hybrid adjustable-rate and
fixed-rate mortgage-backed securities. We expect to pay market rates for
brokerage fees and commissions when purchasing the securities. Until such assets
can be identified and obtained, we intend to temporarily invest the balance of
the proceeds of this offering in readily marketable interest-bearing assets
consistent with our intention to qualify as a REIT.
Set forth below is a tabular presentation of the expected uses of the gross
proceeds of this offering, based on the public offering price of $14.00 per
share. The information is presented assuming no exercise and full exercise,
respectively, of the underwriters' over-allotment option to purchase additional
shares. All amounts in the table are estimates.
NO EXERCISE OF FULL EXERCISE OF
OVER-ALLOTMENT OPTION OVER-ALLOTMENT OPTION
----------------------- -----------------------
DOLLARS PERCENT DOLLARS PERCENT
------------- ------- ------------- -------
(IN MILLIONS) (IN MILLIONS)
Gross offering proceeds............................ $168.0(1) 100.00% $193.2(2) 100.00%
Public offering proceeds
Underwriting discount and commissions............ 10.1 6.00 11.6 6.00
Paid to affiliate................................ 0.0 0.00 0.0 0.00
Offering expenses................................ 0.4(3) 0.25 0.4(3) 0.21
------ ------ ------ -------
Net offering proceeds.............................. $157.5 93.75% $181.2 93.79%
====== ====== ====== =======
Amount of net proceeds used for acquisition of
mortgage-backed securities
Net purchases of mortgage-backed securities...... $157.4 93.70% $181.1 93.74%
Estimated commissions on purchases of mortgage-
backed securities............................. 0.1(4) 0.05 0.1(4) 0.05
Estimated commissions paid to lenders in
connection with borrowings used for
acquisitions.................................. 0.0 0.0 0.0 0.0
Amount of net proceeds used to pay cash component
of management fees............................... 0.0 0.0 0.0 0.0
Amount of net proceeds used for general corporate
or working capital purposes...................... 0.0 0.0 0.0 0.0
Amount of net proceeds used to pay cash
distribution payable on April 26, 2004........... 0.0(5) 0.0 0.0(5) 0.0
------ ------ ------ -------
Total net offering proceeds used................... 157.5 93.75 181.2 93.79
Public offering expenses........................... 10.5 6.25 12.0 6.21
------ ------ ------ -------
Total application of gross offering proceeds....... $168.0 100.00% $193.2 100.00%
====== ====== ====== =======
---------------
(1) Assumes the sale of 12,000,000 shares by us at the public offering price of
$14.00 per share.
(2) Assumes the sale of 13,800,000 shares by us at the public offering price of
$14.00 per share.
(3) Includes the SEC registration fee of $24,478, the NASD filing fee of
$19,820, accounting fees and expenses of $30,000, legal fees and expenses of
$200,000, printing fees and expenses of $50,000, and miscellaneous offering
expenses of $75,702.
(4) Mortgage-backed securities do not trade with commissions. For purposes of
this table, we have assumed an average commission on the purchase of
mortgage-backed securities of approximately 0.05%.
(5) On March 9, 2004, our board of directors declared a cash distribution of
$0.42 per share to stockholders of record on March 19, 2004, payable on
April 26, 2004.
32
MARKET PRICE OF AND DISTRIBUTIONS ON OUR COMMON STOCK
MARKET INFORMATION
Prior to our IPO, our common stock was not listed or quoted on any national
exchange or market system. However, certain of our stockholders privately sold
shares of our common stock using the PORTAL system. Since December 19, 2003, our
common stock has been listed on the NYSE under the symbol "LUM." The following
table sets forth the high and low sale prices for our common stock as reported
on the PORTAL Market of which we are aware (for dates prior to December 19,
2003) and as reported on the NYSE (for dates on or after December 19, 2003) for
each quarterly period since June 11, 2003, the date of our private placement:
COMMON STOCK
---------------
HIGH LOW
------ ------
2003
Second Quarter (from June 11, 2003)......................... $15.35 $15.00
Third Quarter............................................... $15.60 $15.00
Fourth Quarter.............................................. $15.00 $13.00
2004
First Quarter (through March 29, 2004)...................... $15.35 $13.77
As of March 29, 2004, we had 24,841,146 shares of our common stock issued
and outstanding which were held by 17 holders of record. The 17 holders of
record include Cede & Co., which holds shares as nominee for The Depository
Trust Company, which itself holds shares on behalf of hundreds of beneficial
owners of our common stock. Our common stock was sold privately from time to
time prior to our IPO, and certain of those trades were reported on the PORTAL
Market; however, the information above regarding PORTAL Market prices may not be
complete since we have access only to information regarding trades that were
reported by our underwriters and not trades that may have been reported by other
broker-dealers. Moreover, broker-dealers are not obligated to report all trades
to PORTAL.
DISTRIBUTION POLICY
The following table sets forth, for the periods indicated, the cash
distributions declared per share of our common stock since June 11, 2003, the
date of our private placement:
CASH DISTRIBUTIONS
DECLARED PER SHARE
------------------
2003
Second Quarter (from June 11, 2003)......................... $ --
Third Quarter............................................... $ 0.50
Fourth Quarter.............................................. $ 0.45
2004
First Quarter............................................... $ 0.42
Our distributions declared to date are not necessarily indicative of
distributions that we will declare in the future. We expect that future
distributions will be based on our REIT taxable net income in future periods,
which we cannot predict with any certainty. All distribution declarations are
made at the discretion of our board of directors.
On October 1, 2003, we declared a cash distribution of $0.50 per share to
our stockholders of record on October 21, 2003. We paid the distribution on
November 17, 2003. All of the distribution is a taxable dividend, and none of
the distribution is a return of capital. The distribution was funded with cash
flow from our ongoing operations, including principal payments and interest
payments on our mortgage-backed securities.
33
On November 24, 2003, our board of directors declared a cash distribution
of $0.45 per share for the fourth quarter of 2003, which was paid on January 28,
2004 to stockholders of record on December 11, 2003. All of the distribution is
a taxable dividend, and none of the distribution is a return of capital. As
allowed by the Internal Revenue Code for a REIT's fourth quarter distribution,
our January 28, 2004 distribution was deemed to be a dividend made by us on
December 31, 2003 to the extent of our 2003 undistributed earnings and profits
(as determined under the Internal Revenue Code), even though it was paid in
2004. The distribution was funded with cash flow from our ongoing operations,
including principal and interest payments received on our mortgage-backed
securities. We did not distribute $282 thousand of our REIT taxable net income
for the period from April 26, 2003 through December 31, 2003. We intend to
declare a spillback distribution in this amount during 2004.
On March 9, 2004 our board of directors declared a cash distribution of
$0.42 per share for the first quarter of 2004, which will be paid on April 26,
2004 to stockholders of record on March 19, 2004. The aggregate amount of our
first quarter 2004 distribution will be $10.4 million. This public offering will
close after the distribution record date and, accordingly, purchasers of common
stock in this offering will not receive this distribution. Although our results
of operations for the three months ending March 31, 2004 cannot be definitely
predicted at this time, we expect that this cash distribution will be funded
with cash flow from our ongoing operations and not with any portion of the
proceeds from this offering. Our current portfolio generates a monthly cash flow
significantly in excess of this distribution payable amount. For example, for
the three months ended February 29, 2004, we received from our portfolio
combined coupon cash flow and principal payments in the amount of $126.0
million, for an average of $42.0 million per month.
This distribution declaration is irrevocable and is not contingent on our
operating performance. However, if and to the extent that we do not generate
sufficient cash flow from ongoing operations (including principal payments and
interest payments on our mortgage-backed securities) to fund the distribution,
we will need to sell mortgage-backed securities or borrow funds by entering into
repurchase agreements or otherwise borrowing funds under our line of credit to
pay the distribution. We generally do not intend to declare distributions before
our operating results for a period are better known. However, because this
offering is scheduled to close late in the quarter, our board of directors
determined that it would be inequitable to our current stockholders if new
investors participated in the fourth quarter distribution and, accordingly, our
board declared a distribution with a record date prior to this offering's
anticipated closing date.
We intend to distribute all or substantially all of our REIT taxable net
income (which does not ordinarily equate to net income as calculated in
accordance with GAAP) to our stockholders in each year. We intend to make
regular quarterly distributions to our stockholders to be paid out of funds
readily available for such distributions. Our distribution policy is subject to
revision at the discretion of our board of directors without notice to you or
stockholder approval. We have not established a minimum distribution level and
our ability to make distributions may be harmed for the reasons described under
the caption "Risk Factors." All distributions will be made by us at the
discretion of our board of directors and will depend on our earnings and
financial condition, maintenance of REIT status, applicable provisions of the
Maryland general corporation law, or MGCL, and such other factors as our board
of directors deems relevant.
In order to avoid corporate income and excise tax and to maintain our
qualification as a REIT under the Internal Revenue Code, we must make
distributions to our stockholders each year in an amount at least equal to:
- 90% of our REIT taxable net income;
- plus 90% of the excess of net income from foreclosure property over the
tax imposed on such income by the Internal Revenue Code;
- minus any excess non-cash income.
34
In general, our distributions will be applied toward these requirements
only if paid in the taxable year to which they relate, or in the following
taxable year if the distributions are declared before we timely file our tax
return for that year, the distributions are paid on or before the first regular
distribution payment following the declaration and we elect on our tax return to
have a specified dollar amount of such distributions treated as if paid in the
prior year. Distributions declared by us in October, November or December of one
taxable year and payable to a stockholder of record on a specific date in such a
month are treated as both paid by us and received by the stockholder during such
taxable year, provided that the distribution is actually paid by us by January
31 of the following taxable year.
We anticipate that distributions generally will be taxable as ordinary
income to our stockholders, although a portion of such distributions may be
designated by us as capital gain or may constitute a return of capital. We will
furnish annually to each of our stockholders a statement setting forth
distributions paid during the preceding year and their characterization as
ordinary income, return of capital or capital gains.
We will seek to borrow between eight and 12 times the amount of our equity,
and as of December 31, 2003 we had established 17 borrowing agreements with
various investment banking firms and other lenders, 12 of which were in use on
December 31, 2003.
In the future, our board of directors may elect to adopt a dividend stock
purchase plan, which allows for the reinvestment of dividends.
35
CAPITALIZATION
The following table sets forth our capitalization as of December 31, 2003:
- on an actual basis;
- on a pro forma basis to give effect to our cash distribution of $10.4
million declared on March 9, 2004, which is payable on April 26, 2004 to
stockholders of record on March 19, 2004; and
- on an as adjusted basis to give effect to the above pro forma adjustments
and to our sale of 12,000,000 shares of our common stock in this
offering, at the public offering price of $14.00 per share and after
deducting the underwriters' discounts and commissions and estimated
offering expenses payable by us.
DECEMBER 31, 2003
----------------------------------
PRO FORMA
ACTUAL PRO FORMA AS ADJUSTED
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) -------- --------- -----------
Stockholders' equity:
Preferred stock, par value $0.001:
10,000,000 shares authorized; no shares issued and
outstanding actual, pro forma or pro forma as
adjusted........................................ -- -- --
Common stock, par value $0.001:
100,000,000 shares authorized; 24,814,000 shares
issued and outstanding actual and pro forma;
36,814,000 shares issued and outstanding pro
forma as adjusted............................... $ 25 $ 25 $ 37
Additional paid-in capital......................... 317,339 317,339 474,847
Accumulated other comprehensive loss............... (26,510) (26,510) (26,510)
Accumulated distributions in excess of accumulated
earnings........................................ (8,358) (18,780) (18,780)
-------- -------- --------
Total stockholders' equity...................... $282,496 $272,074 $429,594
======== ======== ========
The table above excludes the following shares:
- a total of 55,000 shares of our common stock issuable upon exercise of
options outstanding on December 31, 2003 with a weighted-average exercise
price of $14.82 per share;
- a total of 945,000 shares of our common stock available for awards under
our two stock incentive plans as of December 31, 2003;
- a currently indeterminate number of shares of common stock that might
become issuable in connection with Seneca's incentive fee under the
management agreement; and
- a currently indeterminate number of shares of common stock that might
become issuable in connection with the incentive bonus under Mr. Zyda's
employment agreement.
Subsequent to the date as of which information is presented in the table
above:
- we issued 25,651 shares of our common stock to Seneca as the equity
component of its management fee for the fourth quarter of 2003;
- we issued 1,283 shares of our common stock to Mr. Zyda under our 2003
stock incentive plan as the equity component of his contractual fourth
quarter 2003 incentive bonus;
- we issued 212 shares of our common stock to our controller under our 2003
stock incentive plan as an incentive bonus; and
- we granted an option to the underwriters of this offering to purchase up
to 1,800,000 shares of our common stock from us, solely to cover
over-allotments.
36
DILUTION
Our net tangible book value as of December 31, 2003 was approximately
$282.5 million, or $11.38 per share of our common stock. If you invest in our
common stock, your interest will be diluted to the extent of the difference
between the price you pay per share of our common stock and the net tangible
book value per share of our common stock at the time of your purchase. Net
tangible book value per share is calculated by subtracting our total liabilities
from our total tangible assets, which is total assets less intangible assets,
and dividing this amount by the number of shares of our common stock issued and
outstanding. After giving effect to the sale by us of 12,000,000 shares of our
common stock in this offering, at the public offering price of $14.00 per share,
and after deducting the underwriters' discounts and commissions and estimated
offering expenses payable by us, our net tangible book value as of December 31,
2003 would have been $440.0 million, or $11.95 per share of our common stock.
This represents an immediate increase in the net tangible book value of $0.57
per share to our existing stockholders and an immediate and substantial dilution
in net tangible book value of $2.05 per share to new investors. The following
table illustrates this per share dilution:
Public offering price per share............................. $14.00
Net tangible book value per share as of December 31,
2003................................................... $11.38
Increase per share attributable to new investors.......... 0.57
------
Net tangible book value per share........................... 11.95
------
Dilution per share to new investors......................... $ 2.05
======
The following table summarizes the total number of shares of our common
stock purchased from us, the total consideration paid to us (gross proceeds) and
the average price per share paid by existing stockholders and by new investors,
in each case based on the number of shares of our common stock outstanding as of
December 31, 2003 and the public offering price of $14.00 per share.
SHARES PURCHASED TOTAL CONSIDERATION
-------------------- ---------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
---------- ------- ------------ ------- -------------
Shares purchased in April
2003(1)..................... 204,000 0.6% $ 204 0.0% $0.001
Other existing stockholders... 24,610,000 66.8 342,502,097 67.1 13.92
New investors................. 12,000,000 32.6 168,000,000 32.9 14.00
---------- ----- ------------ -----
Total/Weighted-average... 36,814,000 100.0% 510,502,301 100.0% $13.87
========== ===== ============ =====
---------------
(1) 161,160 of the shares purchased in April 2003 were purchased by affiliates
of Seneca.
If the underwriters' over-allotment is exercised in full, the 24,814,000
shares of our common stock held by existing stockholders immediately after this
offering would comprise 64.3% of the total number of shares of our common stock
and the number of shares of our common stock held by new investors would
increase to 13,800,000 shares, or 35.7% of the total number of shares of our
common stock outstanding immediately after this offering.
The foregoing discussion and table are based upon 24,814,000 shares
actually issued and outstanding as of December 31, 2003. As of that date, there
were also 55,000 options outstanding at a weighted-average exercise price of
$14.82 per share and there were a total of 945,000 shares available for future
awards under our stock incentive plans. Subsequent to December 31, 2003 we
issued the following shares and options:
- we issued 25,651 shares of our common stock issued to Seneca as the
equity component of its management fee for the fourth quarter of 2003;
- we issued 1,283 shares of our common stock issued to Mr. Zyda under our
2003 stock incentive plan as the equity component of his contractual
fourth quarter 2003 incentive bonus; and
- we issued 212 shares of our common stock to our controller under our 2003
stock incentive plan as an incentive bonus.
37
BUSINESS
THE COMPANY
BACKGROUND
We were formed in April 2003 to invest primarily in U.S. agency and other
highly-rated, single-family, adjustable-rate, hybrid adjustable-rate and
fixed-rate mortgage-backed securities, which we acquire in the secondary market.
Our strategy is to acquire mortgage-related assets, finance these purchases in
the capital markets and use leverage in order to provide an attractive return on
stockholders' equity. Through this strategy, we seek to earn income, which is
generated from the spread between the yield on our earning assets and our costs,
including the interest cost of the funds we borrow.
We commenced operations in June 2003, following the completion of a private
placement of our common stock, in which we raised net proceeds of approximately
$159.7 million. On December 18, 2003, we completed our IPO of our common stock,
raising approximately $157.0 million in net proceeds. Our common stock began
trading on the NYSE under the trading symbol "LUM" on December 19, 2003. We
received the net proceeds from our IPO in late December. As of December 31,
2003, we had invested substantially all of the net proceeds from that offering,
plus approximately $1.7 billion of borrowed funds, for a total of $2.2 billion
of U.S. agency and other highly-rated, residential mortgage-backed securities.
However, at December 31, 2003, we had not fully levered our portfolio to within
our target range of eight to 12 times the amount of our equity. As a result, the
total amount of mortgage-backed securities and repurchase agreement liabilities
as of December 31, 2003 were lower than if we had fully levered our portfolio
through additional repurchase agreement liabilities and related mortgage-backed
security purchases.
We are externally managed and advised by Seneca pursuant to a management
agreement.
We will elect to be taxed as a REIT under the Internal Revenue Code of
1986, as amended, commencing with the taxable year ended December 31, 2003. As
such, we will routinely distribute substantially all of the income generated
from our operations to our stockholders. As long as we retain our REIT status,
we generally will not be subject to U.S. federal or state taxes on our income to
the extent that we distribute our net income to our stockholders.
ASSETS
We invest primarily in adjustable-rate and hybrid adjustable-rate
mortgage-backed securities. Adjustable-rate mortgage-backed securities have
interest rates that reset periodically, typically every six months or on an
annual basis. Hybrid adjustable-rate mortgage-backed securities have interest
rates that are fixed for the first few years of the loan -- typically three,
five, seven or 10 years -- and thereafter reset periodically in a manner similar
to adjustable-rate mortgage-backed securities. See Note 3 to the financial
statements for further discussion.
With the net proceeds of this offering and other borrowed funds, we intend
to invest in mortgage-backed securities similar to those currently in our
portfolio. We will seek to acquire mortgage-backed securities that will produce
competitive returns, taking into consideration the amount and nature of the
anticipated returns from the investment, our ability to pledge the investment
for secured, collateralized borrowings and the costs associated with financing,
managing, securitizing and reserving for these investments. As of the date of
this prospectus, we have not identified any specific mortgage-backed securities
that we intend to acquire with the net proceeds of this offering. All of the
mortgage-backed securities that we acquired with the net proceeds of our recent
IPO are agency-backed or have AAA credit ratings from at least one
nationally-recognized statistical rating agency, and all of the securities are
either adjustable-rate or hybrid adjustable-rate mortgage-backed securities. We
expect that the substantial majority, or perhaps the entirety of the
mortgage-backed securities that we acquire with the net proceeds of this
offering will be agency-backed or have AAA credit ratings.
38
We review the credit risk associated with each potential investment and may
diversify our portfolio to avoid undue geographic, insurer, industry and other
types of concentrations. By maintaining a large percentage of our assets in high
quality and highly-rated assets, many of which are guaranteed under limited
circumstances as to payment of a limited amount of principal and interest by
federal agencies or federally chartered entities such as Fannie Mae, Freddie Mac
or Ginnie Mae, we believe we can mitigate our exposure to losses from credit
risk.
We have financed our acquisition of mortgage-backed securities by investing
our equity and by borrowing at short-term rates under repurchase agreements. We
intend to continue to finance our acquisitions in this manner.
BORROWINGS
We have established 17 borrowing arrangements with various investment
banking firms and other lenders, 12 of which were in use on December 31, 2003.
These borrowing arrangements facilitated our purchase of our initial portfolio
of securities and provided us with sufficient borrowing capacity to fully
leverage the net proceeds of our initial public offering. The repurchase
agreements were secured by mortgage-backed securities. We intend to seek to
renew repurchase agreements as they mature under the then-applicable borrowing
terms of the counterparties to our repurchase agreements. See Note 4 to the
financial statements for further discussion.
We generally seek to borrow between eight and 12 times the amount of our
equity. We actively manage the adjustment periods and the selection of the
interest rate indices of our borrowings against the adjustment periods and the
selection of indices on our mortgage-backed securities in order to manage our
liquidity and interest rate related risks.
HEDGING
We may also choose to engage in various hedging activities designed to
match more closely the terms of our assets and liabilities. Currently, we are
engaged in short sales of Eurodollar futures contracts as a means of mitigating
our interest rate risk on forecasted interest expense associated with the
benchmark rate on forecasted rollover/reissuance of repurchase agreements. The
value of these futures contracts is marked-to-market daily in our margin account
with the custodian. Based upon the daily market value of these futures
contracts, we either receive funds into, or wire funds into, our margin account
with the custodian to ensure that an appropriate margin account balance is
maintained at all times through the expiration of the contracts. See Note 12 to
the financial statements for further discussion.
DISTRIBUTIONS
On November 17, 2003, we paid a cash distribution of $0.50 per share to our
stockholders of record on October 21, 2003. On January 28, 2004, we paid a cash
distribution of $0.45 per share to our stockholders of record on December 11,
2003. Both of these distributions are taxable dividends, and neither of these
distributions are considered return of capital. The distributions were funded
with cash flow from our ongoing operations, including principal payments and
interest payments on our mortgage-backed securities.
On March 9, 2004 our board of directors declared a cash distribution of
$0.42 per share for the first quarter of 2004, which will be paid on April 26,
2004 to stockholders of record on March 19, 2004. The aggregate amount of our
first quarter 2004 distribution will be $10.4 million. This public offering will
close after the distribution record date and, accordingly, purchasers of common
stock in this offering will not receive this distribution. Although our results
of operations for the three months ending March 31, 2004 cannot be definitely
predicted at this time, we expect that this cash distribution will be funded
with cash flow from our ongoing operations and not with any portion of the
proceeds from this offering. Our current portfolio generates a monthly cash flow
significantly in excess of this distribution payable amount. For example, for
the three months ended February 29, 2004, we received from our portfolio
combined coupon cash flow and principal payments in the amount of $126.0
million, for an average of $42.0 million per
39
month. To the extent that our cash flow from our ongoing operations might be
insufficient, we will fund the distribution with sales of mortgage-backed
securities and/or borrowings under repurchase agreements or our credit lines.
BUSINESS STRATEGY
OUR OPERATING POLICIES AND PROGRAMS
Our board of directors has established the following four primary operating
policies to implement our business strategies:
- asset acquisition policy;
- capital/liquidity and leverage policies;
- credit risk management policy; and
- asset/liability management policy.
ASSET ACQUISITION POLICY
Our asset acquisition policy provides guidelines for acquiring investments
in order to maintain compliance with our overall investment strategy. In
particular, we acquire a portfolio of investments that can be grouped into
specific categories. Each category and our respective investment guidelines are
as follows:
- Category I -- At least 75% of our total assets will generally be
residential mortgage-related securities and short-term investments.
Assets in this category are rated within one of the two highest rating
categories by at least one nationally-recognized statistical rating
organization, or will be obligations guaranteed by federal agencies or
federally chartered agencies, such as Fannie Mae, Freddie Mac or Ginnie
Mae.
- Category II -- At least 90% of our total assets will consist of Category
I investments plus mortgage-related securities that are rated at least
investment grade by at least one nationally-recognized statistical rating
organization.
- Category III -- No more than 10% of our total assets may be of a type not
meeting any of the above criteria. Among the types of assets generally
assigned to this category are mortgage-related securities rated below
investment grade and leveraged mortgage derivative securities, or shares
of other REITs, or other investments.
We expect to acquire only those mortgage-related assets which we believe
our manager has the necessary expertise to evaluate and manage, which we can
readily finance, and which are consistent with our overall investment strategy
and our asset acquisition policy. Generally, we expect to hold our
mortgage-backed securities until maturity. Therefore, we generally do not seek
to acquire assets with investment returns that are attractive only in a limited
range of scenarios. Future interest rates and mortgage prepayment rates are very
difficult to predict and, as a result, we seek to acquire mortgage-backed
securities which we believe provide acceptable returns over a broad range of
interest rate and prepayment scenarios.
We expect most of our acquisitions to consist of adjustable-rate
mortgage-backed securities, hybrid adjustable-rate mortgage-backed securities
and fixed-rate mortgage-backed securities. We anticipate that our investments in
fixed-rate mortgage-backed securities will be focused in shorter-term mortgages,
including balloon mortgages. We may, however, purchase longer-term fixed-rate
mortgage-backed securities if we view the potential net returns as attractive or
if the acquisition of such assets serves to reduce or diversify the overall risk
profile of our portfolio.
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CAPITAL/LIQUIDITY AND LEVERAGE POLICIES
We employ a leverage strategy to increase our investment assets by
borrowing against existing mortgage-backed securities and using the proceeds to
acquire additional mortgage-backed securities. We generally seek to borrow
between eight to 12 times the amount of our equity, although our borrowings may
vary from time to time depending on market conditions and other factors deemed
relevant by our manager and our board of directors. We believe that this leaves
an adequate capital base to protect against interest rate environments in which
our borrowing costs might exceed our interest income from mortgage-backed
securities.
Depending on the different cost of borrowing funds at different maturities,
we expect to vary the maturities of our borrowed funds to attempt to produce
lower borrowing costs. In general, our borrowings are short-term. We actively
manage, on an aggregate basis, both the interest-rate indices and interest-rate
adjustment periods of our borrowings against the interest-rate indices and
interest-rate adjustment periods related to our mortgage-backed securities.
We expect to continue to finance our mortgage-backed securities primarily
at short-term borrowing rates through repurchase agreements and, to a lesser
extent, our equity capital. We anticipate that, upon repayment of each borrowing
under a repurchase agreement, we will use the collateral immediately for
borrowing under a new repurchase agreement. In the future we may also employ
borrowings under lines of credit, term loans and other collateralized financings
that we may establish with approved institutional lenders and we may employ
long-term borrowings.
We have established 17 borrowing arrangements with various investment
banking firms and other lenders. A repurchase agreement, although structured as
a sale and repurchase obligation, acts as a financing under which we effectively
pledge our mortgage-backed securities as collateral to secure a short-term loan.
Generally, the other party to the agreement makes the loan in an amount equal to
a percentage of the market value of the pledged collateral. At the maturity of
the repurchase agreement, we are required to repay the loan and correspondingly
receive back our collateral. While used as collateral, the mortgage-backed
securities continue to pay principal and interest to us. In the event of our
insolvency or bankruptcy, certain repurchase agreements may qualify for special
treatment under the U.S. Federal Bankruptcy Code, the effect of which, among
other things, would be to allow the creditor under the agreement to avoid the
automatic stay provisions of the U.S. Federal Bankruptcy Code and to foreclose
on the collateral agreement without delay. In the event of the insolvency or
bankruptcy of the lender during the term of a repurchase agreement, the lender
may be permitted, under applicable insolvency laws, to repudiate the contract,
and our claim against the lender for damages may be treated simply as an
unsecured creditor. In addition, if the lender is a broker or dealer subject to
the Securities Investor Protection Act of 1970, or an insured depository
institution subject to the Federal Deposit Insurance Act, our ability to
exercise our rights to recover our securities under a repurchase agreement or to
be compensated for any damages resulting from the lender's insolvency may be
further limited by those statutes. These claims would be subject to significant
delay and, if and when received, may be substantially less than the damages we
actually incur. As a result, we expect to enter into collateralized borrowings
only with institutions that we believe are financially sound and which are rated
investment grade by at least one nationally-recognized statistical rating
organization.
Substantially all of our borrowing agreements require us to deposit
additional collateral in the event the market value of existing collateral
declines, which may require us to sell assets to reduce our borrowings. We have
designed our liquidity management policy to maintain an adequate capital base
sufficient to provide required liquidity to respond to the effects under our
borrowing arrangements of interest rate movements and changes in the market
value of our mortgage-backed securities, as described above. However, a major
disruption in the repurchase or other market that we rely on for short-term
borrowings would harm our results of operations unless we were able to arrange
alternative sources of financing on comparable terms.
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CREDIT RISK MANAGEMENT POLICY
We review credit risk associated with each of our potential investments. In
addition, we may diversify our portfolio of mortgage-backed securities to avoid
undue geographic, insurer, industry and certain other types of concentration
risk. We may reduce risk from sellers and servicers by obtaining representations
and warranties. Our manager monitors the overall portfolio risk in order to
determine appropriate levels of provision for losses we may experience.
We generally determine, at the time of purchase, whether or not a
mortgage-related asset complies with our credit risk management policy
guidelines, based upon the most recent information utilized by us. Such
compliance is not expected to be affected by events subsequent to such purchase,
such as changes in characterization, value or rating of any specific
mortgage-related assets or economic conditions or events generally affecting any
mortgage-related assets of the type held by us.
ASSET/LIABILITY MANAGEMENT POLICY
Interest Rate Risk Management. To the extent consistent with our election
to qualify as a REIT, we follow an interest rate risk management program
intended to protect our portfolio of mortgage-backed securities and related debt
against the effects of major interest rate changes. Specifically, our interest
rate management program is formulated with the intent to offset, to some extent,
the potential adverse effects resulting from rate adjustment limitations on our
mortgage-backed securities and the differences between interest rate adjustment
indices and interest rate adjustment periods of our adjustable-rate mortgage-
backed securities and related borrowings.
Our interest rate risk management program encompasses a number of
procedures, including the following:
- monitoring and adjusting, if necessary, the interest rate sensitivity of
our mortgage-backed securities compared with the interest rate
sensitivities of our borrowings;
- attempting to structure our borrowing agreements to have a range of
different maturities and interest rate adjustment periods (although
substantially all will be less than one year); and
- actively managing, on an aggregate basis, the interest rate indices,
interest rate adjustment periods, and gross reset margins of the
mortgages underlying our mortgage-backed securities compared to the
interest rate indices and adjustment periods of our borrowings.
As a result, we expect to be able to adjust the average maturity/adjustment
period of our borrowings on an ongoing basis by changing the mix of maturities
and interest rate adjustment periods as borrowings mature or are renewed.
Through the use of these procedures, we attempt to reduce the risk of
differences between interest rate adjustment periods of the mortgages underlying
our adjustable-rate mortgage-backed securities and our related borrowings.
It is generally our intention to manage the assets in our portfolio with
regard to risk characteristics such as duration, in order to carefully limit the
overall interest rate risk of the portfolio. On occasion, we may alter the
overall duration in order to better protect the portfolio in order to protect
shareholder value. Similarly, it is our intention to manage the duration of our
liabilities. Generally, we will seek to reduce the gap between the duration of
our assets and our liabilities to a level which is consistent with protection of
the portfolio during volatile interest rate environments. The means by which we
will accomplish this objective will vary over time, and may include the use of
hedging instruments and the alteration of the duration of the asset and/or the
liability side of our balance sheet through asset purchases or sales and through
the assumption or the retirement of repurchase agreements of varying maturities
or the structuring of other financing arrangements.
Depending on market conditions and the cost of the transactions, we may
conduct hedging activities in connection with our portfolio management. When we
engage in hedging activities, we intend to do so in a manner consistent with our
election to qualify as a REIT. The goal of any hedging strategy we adopt will be
to lessen the effects of interest rate changes and to enable us to earn net
interest income in periods of
42
generally rising, as well as declining or static, interest rates. Specifically,
if we implement a hedging program, it would likely be formulated with the intent
to offset some of the potential adverse effects of changes in interest rate
levels relative to the interest rates on the mortgage-backed securities held in
our investment portfolio, as well as differences between the interest rate
adjustment indices and maturity or reset periods related to our mortgage-backed
securities and our borrowings.
Under the REIT rules of the Internal Revenue Code, some hedging activities
produce income which is not qualifying income for purposes of the REIT gross
income tests or create assets which are not qualifying assets for purposes of
the REIT assets test. As a result, we may have to terminate certain hedging
activities before the benefits of such activities are realized. In the case of
excess hedging income, we would be required to pay a penalty tax for failure to
satisfy certain REIT income tests under the Internal Revenue Code if the excess
is due to reasonable cause and not willful neglect. In the case of having excess
value in relation to mortgage-related assets, the penalty would result in our
disqualification as a REIT. In addition, asset/liability management involves
transaction costs that increase dramatically as the period covered by hedging
protection increases and that may increase during periods of fluctuating
interest rates.
Prepayment Risk Management. We also seek to lessen the effects of
prepayment of mortgage loans underlying our securities at a faster or slower
rate than anticipated. We expect to accomplish this by using a variety of
techniques which include, without limitation, structuring a diversified
portfolio with a variety of prepayment characteristics, investing in
mortgage-backed securities based on mortgage loans with prepayment prohibitions
and penalties, investing in certain mortgage security structures that have
prepayment protections, and purchasing mortgage-backed securities at a premium
and at a discount. We intend to monitor prepayment risk through the periodic
review of the impact of a variety of prepayment scenarios on our revenues, net
earnings, distributions, cash flow and net balance sheet market value.
We believe that we have developed cost-effective asset/liability management
policies to mitigate interest rate and prepayment risks. We continually monitor
our risk management strategies as market conditions change. However, no strategy
can completely insulate us from interest rate and prepayment risks. Further, as
noted above, certain of the U.S. federal income tax requirements that we must
satisfy to qualify as a REIT limit our ability to fully hedge our interest rate
and prepayment risks. Therefore, we could be prevented from effectively hedging
our interest rate and prepayment risks.
DESCRIPTION OF MORTGAGE-RELATED ASSETS
MORTGAGE-BACKED SECURITIES
Pass-Through Certificates. We expect principally to invest in pass-through
certificates, which are securities representing interests in pools of mortgage
loans secured by residential real property in which payments of both interest
and principal on the securities are generally made monthly. In effect, these
securities pass through the monthly payments made by the individual borrowers on
the mortgage loans that underlie the securities, net of fees paid to the issuer
or guarantor of the securities. Pass-through certificates can be divided into
various categories based on the characteristics of the underlying mortgages,
such as the term or whether the interest rate is fixed or variable.
A key feature of most mortgage loans is the ability of the borrower to
repay principal earlier than scheduled. This is called a prepayment. Prepayments
can arise due to sale of the underlying property, refinancing, foreclosure, or
other events. Prepayments result in a return of principal to pass-through
certificate holders. This may result in a lower or higher rate of return upon
reinvestment of principal. This is generally referred to as prepayment
uncertainty. If a security purchased at a premium pre-pays at a higher than
expected rate, then the value of the premium would be eroded at a faster than
expected rate. Similarly, if a discount mortgage pre-pays at a lower than
expected rate, the amortization towards par would be accumulated at a slower
than expected rate. The possibility of these undesirable effects is sometimes
referred to as "prepayment risk."
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In general, but not always, declining interest rates tend to increase
prepayments, and rising interest rates tend to slow prepayments. Like other
fixed-income securities, when interest rates rise, the value of mortgage-backed
securities generally decline. The rate of prepayments on underlying mortgages
will affect the price and volatility of mortgage-backed securities and may have
the effect of shortening or extending the effective maturity of the security
beyond what was anticipated at the time of purchase. If interest rates rise, our
holdings of mortgage-backed securities may experience reduced returns if the
borrowers of the underlying mortgages pay off their mortgages later than
anticipated. This is generally referred to as extension risk.
Payment of limited amounts of principal and interest on some mortgage
pass-through securities, although not the market value of the securities
themselves, may be guaranteed by the full faith and credit of the federal
government, including securities backed by Ginnie Mae, or by agencies or
instrumentalities of the federal government, including Fannie Mae or Freddie
Mac. Mortgage-backed securities created by non-governmental issuers, including
commercial banks, savings and loan institutions, private mortgage insurance
companies, mortgage bankers and other secondary market issuers, may be supported
by various forms of insurance or guarantees, including individual loan, title,
pool and hazard insurance and letters of credit, which may be issued by
governmental entities, private insurers or the mortgage poolers.
The mortgage loans underlying pass-through certificates can generally be
classified in the following four categories:
- Adjustable-Rate Mortgages. Adjustable-rate mortgages, or ARMs, are those
for which the borrower pays an interest rate that varies over the term of
the loan. The interest rate usually resets based on market interest
rates, although the adjustment of such an interest rate may be subject to
certain limitations. Traditionally, interest rate resets occur at regular
set intervals (for example, once per year). We will refer to such ARMs as
"traditional" ARMs. Because the interest rates on ARMs fluctuate based on
market conditions, ARMs tend to have interest rates that do not deviate
from current market rates by a large amount. This in turn can mean that
ARMs have less price sensitivity to interest rates. This may be
attractive to some mortgage investors.
- Fixed-Rate Mortgages. Fixed-rate mortgages are those where the borrower
pays an interest rate that is constant throughout the term of the loan.
Traditionally, most fixed-rate mortgages have an original term of 30
years. However, shorter terms (also referred to as final maturity dates)
have become common in recent years. Because the interest rate on the loan
never changes, even when market interest rates change, over time there
can be a divergence between the interest rate on the loan and current
market interest rates. This in turn can make a fixed-rate mortgage's
price sensitive to market fluctuations in interest rates. In general, the
longer the remaining term on the mortgage loan, the greater the price
sensitivity. One way to attempt to lower the price sensitivity of a
portfolio of fixed-rate mortgages is to buy those with shorter remaining
terms or maturities.
- Hybrid Adjustable-Rate Mortgages. A recent development in the mortgage
market has been the popularity of ARMs that do not reset at regular
intervals. Many of these ARMs have a fixed-rate for the first few years
of the loan -- typically three, five, seven or 10 years -- and thereafter
reset periodically like a traditional ARM. Effectively such mortgages are
hybrids, combining the features of a pure fixed-rate mortgage and a
"traditional" ARM. Hybrid ARMs have a price sensitivity to interest rates
similar to that of a fixed-rate mortgage during the period when the
interest rate is fixed and similar to that of an ARM when the interest
rate is in its periodic reset stage. However, because many hybrid ARMs
are structured with a relatively short initial time span during which the
interest rate is fixed, even during that segment of its existence, the
price sensitivity may be low. The ability of hybrid ARMs to exhibit low
price sensitivity to interest rates can be attractive to some mortgage
investors.
- Balloon Maturity Mortgages. Balloon maturity mortgages are a type of
fixed-rate mortgage. Thus, they have a static interest rate for the life
of the loan. However the term of the loan is usually quite short and is
less than the amortization schedule of the loan. Typically, this term or
maturity is less than seven years. When the mortgage matures, the
investor receives all of his principal back. This
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is effectively a price reset of the invested principal to par. As the
balloon maturity mortgage approaches its maturity date, the price
sensitivity of the mortgage declines. In fact, the price sensitivity for
an agency balloon mortgage with a set maturity is actually lower than
that for an agency hybrid ARM with the same time to interest rate reset.
The ability of a balloon mortgage to have low price sensitivity to
interest rates can be attractive for some mortgage investors.
Collateralized Mortgage Obligations. Collateralized mortgage obligations,
or CMOs, are a type of mortgage-backed security. Interest and principal on a CMO
are paid, in most cases, on a monthly basis. CMOs may be collateralized by whole
mortgage loans, but are more typically collateralized by portfolios of mortgage
pass-through securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae.
CMOs are structured into multiple classes, or tranches, with each class bearing
a different stated maturity. Monthly payments of principal, including
prepayments, are first returned to investors holding the shortest maturity
class; investors holding the longer maturity classes receive principal only
after the first class has been retired.
Generally, fixed-rate mortgages are used to collateralize CMOs. However,
the CMO tranches need not all have fixed-rate coupons. Some CMO tranches have
floating rate coupons that adjust based on market interest rates, subject to
some limitations. Such tranches, often called "CMO floaters," can have
relatively low price sensitivity. As is the case with traditional ARMs, hybrid
ARMs and balloons, this low price sensitivity may be attractive to some mortgage
investors.
Mortgage Derivative Securities. Although we do not have any intention to
do so in the near term, we may acquire mortgage derivative securities in an
amount not to exceed 10% of our total assets. Mortgage derivative securities
allow the holder to receive interest only, principal only, or interest and
principal in amounts that are disproportionate to those payable on the
underlying mortgage loans. Payments on mortgage derivative securities can be
highly sensitive to the rate of prepayments on the underlying mortgage loans. In
the event of faster or slower than anticipated prepayments on these mortgage
loans, the rates of return on interests in mortgage derivative securities
representing the right to receive interest only or a disproportionately large
amount of interest, or interest only derivatives, would be likely to decline or
increase, respectively. Conversely, the rates of return on mortgage derivative
securities representing the right to receive principal only or a
disproportionate amount of principal, or principal only derivatives, would be
likely to increase or decrease in the event of faster or slower prepayment
speeds, respectively.
We may also invest in inverse floaters, a class of CMOs with a coupon rate
that resets in the opposite direction from the market rate of interest to which
it is indexed, including LIBOR or the 11th District Cost of Funds Index, or
COFI. Any rise in the index rate, which can be caused by an increase in interest
rates, causes a drop in the coupon rate of an inverse floater while any drop in
the index rate causes an increase in the coupon of an inverse floater. An
inverse floater may behave like a leveraged security since its interest rate
usually varies by a magnitude much greater than the magnitude of the index rate
of interest. The leverage-like characteristics inherent in inverse floaters are
associated with greater volatility in their market prices.
We may also invest in other mortgage derivative securities that may be
developed in the future.
Subordinated Interests. We may also acquire subordinated interests, which
are classes of mortgage-backed securities that are junior to other classes of
the same series of mortgage-backed securities in the right to receive payments
from the underlying mortgage loans. The subordination may be for all payment
failures on the mortgage loans securing or underlying such series of mortgage
securities. The subordination will not be limited to those resulting from
particular types of risks, including those resulting from war, earthquake or
flood, or the bankruptcy of a borrower. The subordination may be for the entire
amount of the series of mortgage-related securities or may be limited in amount.
MORTGAGE LOANS
We may acquire and accumulate mortgage loans (i.e., fixed-rate, ARMs,
hybrid and balloon mortgage loans) as part of our investment strategy until a
sufficient quantity has been accumulated for securitization
45
into high-quality mortgage-backed securities in order to enhance their value and
liquidity. Pursuant to our asset acquisition policies, the aggregate amount of
any mortgage loans that we acquire and do not immediately securitize, together
with our investments in other mortgage-related assets that are not Category I or
Category II assets, will not constitute more than 10% of our total assets at any
time. All mortgage loans, if any, will be acquired with the intention of
securitizing them into high-credit quality mortgage securities. Despite our
intentions, however, we may not be successful in securitizing these mortgage
loans. To meet our investment criteria, mortgage loans acquired by us will
generally conform to the underwriting guidelines established by Fannie Mae,
Freddie Mac, Ginnie Mae or other credit insurers. Applicable banking laws
generally require that an appraisal be obtained in connection with the original
issuance of mortgage loans by the lending institution. We do not intend to
obtain additional appraisals at the time of acquiring any mortgage loans.
Mortgage loans may be originated by or purchased from various suppliers of
mortgage-related assets throughout the United States, including savings and
loans associations, banks, mortgage bankers and other mortgage lenders. We may
acquire mortgage loans directly from originators and from entities holding
mortgage loans originated by others. Our board of directors has not established
any limits upon the geographic concentration of mortgage loans that we may
acquire. However, our asset acquisition policy will limit the amount and/or type
of mortgage loans we may acquire.
OTHER INVESTMENTS
We may acquire other investments that include equity and debt securities
issued primarily by other mortgage-related finance companies, interests in
mortgage-related collateralized bond obligations, other subordinated interests
in pools of mortgage-related assets, commercial mortgage loans and securities,
and residential mortgage loans other than high-credit quality mortgage loans.
These investments are generally considered Category III investments under our
asset acquisition policy and shall be limited to 10% of our total assets.
We also intend to operate in a manner that will not subject us to
regulation under the Investment Company Act. Our board of directors has the
authority to modify or waive our current operating policies and our strategies
without prior notice to you and without stockholder approval.
INVESTMENT STRATEGY
Our strategy is to invest primarily in U.S. agency and other highly-rated
single-family adjustable-rate and fixed-rate mortgage-backed securities. We
acquire these investments in the secondary market and seek to acquire assets
that will produce competitive returns after considering the amount and nature of
the anticipated returns from the investment, our ability to pledge the
investment for secured, collateralized borrowings and the costs associated with
financing, managing, securitizing and reserving for these investments. We do not
construct our overall investment portfolio in order to express a directional
expectation for interest rates or mortgage prepayment rates. Future interest
rates and mortgage prepayment rates are very difficult to predict and, as a
result, we seek to acquire mortgage-backed securities which we believe provide
acceptable returns over a broad range of interest rate and prepayment scenarios.
When evaluating the purchase of mortgage-backed securities, we analyze whether
the purchase will permit us to continue to satisfy the minimum 55% portfolio
whole-pool requirement, with which we must comply to maintain our REIT status.
We also assess the relative value of the mortgage-backed security and how well
it would fit into our existing portfolio of mortgage-backed securities. Many
aspects of a mortgage-backed security, and the dynamic interaction of its
characteristics with those of our portfolio, can influence our perception of
what that security is worth and the amount of premium we would be willing to pay
to own the specific security.
The characteristics of each potential investment we analyze generally
include, but are not limited to, the following:
- origination year -- the underwriting year for the mortgages comprising
the mortgage-backed security. This characteristic helps to determine how
"seasoned" the mortgage-backed security is and
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can influence our expectations for the investment's future cash flows. In
the current low interest rate environment, mortgages that were originated
several years ago (when interest rates were higher) tend to have been
refinanced. Those borrowers who did not refinance their homes during the
period of lower interest rates may be relatively less likely (than more
recent borrowers) to refinance during the remaining life of their
mortgages. Therefore, the expected cash flows from a potential investment
with an earlier origination year could exhibit less sensitivity to
changes in interest rates.
- originator -- the financial services entity that underwrites the
mortgages comprising the mortgage-backed security. Originators do not
have homogeneous underwriting standards. The particular underwriting
standards utilized by an originator tend to influence the characteristics
of the borrowers in its mortgage loan pools which, in turn, can influence
the pool's prepayment rates and other cash flows. When analyzing a pool
of mortgages, it can be useful to review the historical cash flows
exhibited by the originator's prior mortgage loan pools. For example, we
may limit the premium we would be willing to pay for a security if the
originator has a history of early refinancings. The quality of the
originator's underwriting standards and the terms it offers borrowers can
also be important to our purchase decisions. These variables potentially
include the originator's required loan documentation, FICO scores,
loan-to-value ratios, prepayment penalties, cap rates, and assumability
terms. Any of these variables might influence our expectations regarding
the timing of cash flows from an originator's mortgage-backed securities
and, thus, their attractiveness for our portfolio.
- coupon -- the weighted-average mortgage coupon of the mortgage-backed
security. Higher coupons are initially attractive because they can
generate more interest income for us than lower-coupon mortgage-backed
securities. However, the sustainability of cash flows from higher-coupon
pools is less predictable because, all else being equal, higher-coupon
mortgages have a greater probability of being refinanced than
lower-coupon mortgages. We generally analyze a mortgage-backed security's
coupon in comparison to current market rates to form an expectation
regarding how sustainable the interest income from the investment will
be.
- margin -- the spread between an adjustable-rate mortgage's market index
and the interest rate that the borrower must pay to service the mortgage.
Similar to higher coupons, higher margins are attractive because they can
generate more interest income for us than lower-margin mortgage-backed
securities. However, higher-margin mortgage pools may be more prone to
experience faster refinancing rates because high-margin borrowers are
relatively more likely to find opportunities to refinance into mortgages
with lower spreads to the index. As a result, the sustainability of the
yield from an investment in a high-margin mortgage pool is less certain
and the premium we would be willing to pay on such an investment, all
else being equal, is less.
- periodic cap -- the amount by which the interest rate on an
adjustable-rate mortgage can adjust during a specified period, usually
six or 12 months. In rapidly rising interest rate environments, higher
periodic caps are more attractive because they reduce the risk of the
adjustable-rate mortgage coupon not being able to reset fully upwards to
the current market rate. Conversely, in rapidly falling interest rate
environments, lower periodic caps increase the probability that the
mortgage's coupon will reset to a level that remains above the current
market rate.
- lifetime cap -- the maximum interest rate that a specific adjustable-rate
mortgage can have during its lifetime. The lifetime cap of a mortgage is
often correlated with market interest rates at the time of origination.
An adjustable-rate mortgage originated in a low interest rate environment
frequently will have a lower lifetime cap than a comparably structured
mortgage originated in a high interest rate environment. If interest
rates rise sufficiently, an adjustable-rate mortgage with a lifetime cap
can effectively behave like a fixed-rate mortgage because the coupon of
the adjustable-rate mortgage cannot adjust above the lifetime cap, and
will thus remain effectively fixed at that level until rates fall. Higher
lifetime caps tend to make particularly structured hybrid or
adjustable-rate mortgage pools more attractive investment candidates.
47
- time-to-reset -- the number of months before the current coupon of the
hybrid or adjustable-rate mortgage will reset. Time-to-reset is an
important consideration as we structure the timing of interest rate
adjustments on the mortgage-backed securities in our portfolio relative
to changes in our borrowing costs.
- loan-to-value -- the ratio between the original loan amount and the value
of the collateral securing the mortgage loan. We consider this factor
less important in a decision to purchase agency-backed mortgage
securities but it can be an important factor when purchasing non-agency
securities. This factor also influences the subordination levels required
by the national rating agencies to receive AAA-rated status.
- geographic dispersion -- the degree to which the properties underlying
the pooled mortgage loans are geographically dispersed. We prefer greater
geographic dispersion because we wish to limit our exposure to specific
states or regions (which might be experiencing relatively greater
economic difficulties) to create a more stable portfolio.
- price and prepayment expectations -- the expected yield of the
mortgage-backed security under various assumptions about future economic
conditions. A mortgage-backed security's ultimate yield is determined by
its price and its actual prepayment levels. We generally form
expectations, based on the above factors, regarding how the mortgage
pool's prepayment levels will change over time, including in response to
possible changes in prevailing interest rates and other economic
conditions, so as to determine whether its offered price creates a yield
that is attractive and fits well with the expected structure of our
portfolio and our borrowing costs under those scenarios.
We generally consider these factors when evaluating an investment's
relative value and the impact it would likely have on our overall portfolio. We
do not assign a particular weight to any factor because the relative importance
of the various factors varies, depending upon the characteristics we seek for
our portfolio and our borrowing cost structure.
We do not currently originate mortgage loans or provide other types of
financing to the owners of real estate and we do not service any mortgage loans.
However, in the future, we may elect to originate mortgage loans or other types
of financing, and we may elect to service mortgage loans and other types of
financing.
FINANCING STRATEGY
We expect to finance the acquisition of our mortgage-backed securities with
short-term borrowings and term loans with a term of less than one year and, to a
lesser extent, equity capital. After analyzing the then-applicable interest rate
yield curves, we may finance with long-term borrowings from time to time. The
amount of borrowing we employ depends on, among other factors, the amount of our
equity capital. We expect to use leverage to attempt to increase potential
returns to our stockholders. Pursuant to our capital and leverage policy, we
seek to strike a balance between the under-utilization of leverage, which
reduces potential returns to our stockholders, and the over-utilization of
leverage, which increases risk by reducing our ability to meet our obligations
to creditors during adverse market conditions.
We expect to borrow at short-term rates using repurchase agreements.
Repurchase agreements are generally short-term in nature. We intend to actively
manage the adjustment periods and the selection of the interest rate indices of
our borrowings against the adjustment periods and the selection of indices on
our mortgage-backed securities in order to limit our liquidity and interest rate
related risks. We generally seek to diversify our exposure by entering into
repurchase agreements with multiple lenders. In addition, we expect to enter
into repurchase agreements only with institutions we believe are financially
sound and which meet credit standards approved by our board of directors.
INDUSTRY TRENDS
We believe fundamental changes are occurring in the U.S. mortgage market,
resulting in the shifting of investment capital and mortgage-related assets out
of traditional lending and savings institutions and
48
into new forms of mortgage banking and mortgage investment firms, including
those that qualify as REITs under the Internal Revenue Code. We believe that
traditional mortgage investment companies, such as banks, thrifts and insurance
companies, provide less attractive investment structures for investing in
mortgage-related assets because of the costs associated with regulation,
infrastructure and corporate level taxation. As a REIT, we can generally pass
through earnings to our stockholders without incurring an entity-level federal
income tax, thereby allowing us to make higher distributions than institutions
with similar investments that are subject to federal income tax on their
earnings. Additionally, with the development of highly competitive national
mortgage markets (which we believe is partly due to the expansion of government
sponsored enterprises such as Fannie Mae, Freddie Mac and Ginnie Mae), local and
regional mortgage originators have lost market share to more efficient mortgage
originators who compete nationally. The growth of the secondary mortgage market,
including new securitization techniques, has also resulted in financing
structures that can be utilized efficiently to fund leveraged mortgage
portfolios and better manage interest rate risk.
The U.S. residential mortgage market has experienced considerable growth
over the past 11 years, with total outstanding U.S. residential mortgage debt
growing from approximately $3.0 trillion in 1992 to approximately $7.3 trillion
as of December 31, 2003, according to the Federal Reserve. According to the same
source, the total amount of U.S. residential mortgage debt securitized into
mortgage-backed securities has grown from approximately $1.4 trillion in 1992 to
approximately $4.2 trillion as of December 31, 2003, approximately $3.4 trillion
of which was agency-backed and therefore generally consistent with our
investment guidelines. As of December 31, 2003, approximately $51.3 billion of
all available mortgage-backed securities was held by REITs.
COMPETITION
When we invest in mortgage-backed securities and other investment assets,
we compete with a variety of institutional investors, including other REITs,
insurance companies, mutual funds, hedge funds, pension funds, investment
banking firms, banks and other financial institutions that invest in the same
types of assets. Many of these investors have greater financial resources and
access to lower costs of capital than we do. The existence of these competitive
entities, as well as the possibility of additional entities forming in the
future, may increase the competition for the acquisition of mortgage-backed
securities, resulting in higher prices and lower yields on assets.
WEBSITE ACCESS TO OUR PERIODIC SEC REPORTS
The Internet address of our corporate website is www.luminentcapital.com.
We make our periodic SEC reports (on Forms 10-K and 10-Q) and current reports
(on Form 8-K), as well as the beneficial ownership reports filed by our
directors, officers and 10% stockholders (on Forms 3, 4 and 5) available free of
charge through our website as soon as reasonably practicable after they are
filed electronically with the SEC. We may from time to time provide important
disclosures to investors by posting them in the investor relations section of
our website, as allowed by SEC rules. The information on our website is not a
part of this prospectus.
Materials we file with the SEC may be read and copied at the SEC's Public
Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Information on
the operation of the Public Reference Room may be obtained by calling the SEC at
1-800-SEC-0330. The SEC also maintains an Internet website at www.sec.gov that
will contain our reports, proxy and information statements, and other
information regarding our company that we will file electronically with the SEC.
EMPLOYEES
Our day-to-day operations are externally managed and advised by our
manager, Seneca Capital Management LLC. At March 29, 2004 we had three full-time
employees. We employ a full-time chief financial officer, Christopher J. Zyda,
whose primary responsibilities include monitoring Seneca's performance under our
management agreement, as well as a full-time controller and a staff accountant.
49
We do not employ any of our officers other than Mr. Zyda. Our other
executive officers are employees and/or officers of Seneca and are compensated
by Seneca.
FACILITIES
Our principal offices are located at 909 Montgomery Street, Suite 500, San
Francisco, California 94133. We utilize approximately 1,500 square feet of space
provided by Seneca.
LEGAL PROCEEDINGS
At December 31, 2003, there were no pending legal proceedings to which we
were party or of which any of our properties were subject.
50
SELECTED FINANCIAL DATA
The following summary financial data are derived from audited financial
statements as of December 31, 2003 and for the period from April 26, 2003
through December 31, 2003. The selected financial data should be read in
conjunction with the more detailed information contained in the financial
statements and notes thereto and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" included elsewhere in this
prospectus.
FOR THE PERIOD
APRIL 26, 2003
THROUGH
DECEMBER 31, 2003
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) -----------------
STATEMENT OF OPERATIONS DATA:
Revenues:
Net interest income:
Interest income........................................... $ 22,654
Interest expense.......................................... 9,009
-----------
Net interest income.................................... 13,645
Losses on sales of mortgage-backed securities............. (7,831)
Expenses:
Management fee expense to related party................... 901
Incentive fee expense to related party.................... 980
Salaries and benefits..................................... 99
Professional services..................................... 477
Board of directors expense................................ 117
Insurance expense......................................... 291
Custody expense........................................... 115
Other general and administrative expenses................. 73
-----------
Total expenses......................................... 3,053
-----------
Net income.................................................. $ 2,761
===========
Basic and diluted earnings per share........................ $ 0.27
===========
Weighted-average number of shares outstanding, basic........ 10,139,280
===========
Weighted-average number of shares outstanding, diluted...... 10,139,811
===========
DECEMBER 31, 2003
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) -----------------
BALANCE SHEET DATA:
Mortgage-backed securities available-for-sale, at fair
value..................................................... $ 352,123
Mortgage-backed securities available-for-sale, pledged as
collateral, at fair value................................. 1,809,822
Total mortgage-backed securities available-for-sale, at fair
value..................................................... 2,161,945
Total assets................................................ 2,179,340
Repurchase agreements....................................... 1,728,973
Unsettled security purchases................................ 156,127
Total liabilities........................................... 1,896,844
Accumulated other comprehensive loss........................ (26,510)
Total stockholders' equity.................................. 282,496
Book value per share........................................ $ 11.38
51
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of our financial condition and results of
operations should be read in conjunction with the financial statements and notes
to those statements included elsewhere in this prospectus. This discussion may
contain forward-looking statements that involve risks and uncertainties. The
words "believe," "expect," "anticipate," "estimate," "may," "will," or "could"
and similar expressions or the negatives of these words or phrases are intended
to identify forward-looking statements. As a result of many factors, such as
those set forth under "Risk Factors" and elsewhere in this prospectus, our
actual results may differ materially from those anticipated in such
forward-looking statements.
GENERAL
Luminent Mortgage Capital, Inc. is a REIT headquartered in San Francisco,
California. We were incorporated in April 2003 to invest primarily in U.S.
agency and other highly-rated, single-family, adjustable-rate, hybrid
adjustable-rate and fixed-rate mortgage-backed securities, which we acquire in
the secondary market. Substantive operations began mid-June 2003, after
completing a private placement of our common stock. Our strategy is to acquire
mortgage-related assets, finance these purchases in the capital markets and use
leverage in order to provide an attractive return on stockholders' equity.
Through this strategy, we seek to earn income, which is generated from the
spread between the yield on our earning assets and our costs, including the
interest cost of the funds we borrow. We have acquired and will seek to acquire
additional assets that will produce competitive returns, taking into
consideration the amount and nature of the anticipated returns from the
investment, our ability to pledge the investment for secured, collateralized
borrowings and the costs associated with financing, managing, securitizing and
reserving for these investments.
Our business is affected by a variety of economic and industry factors
which management considers. The most significant risk factors management
considers while managing the business which could have a material effect on the
financial condition and results of operations are:
- interest rate mismatches between our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities and our borrowings used to
fund our purchases of mortgage-backed securities;
- increasing or decreasing levels of prepayments on the mortgages
underlying our mortgage-backed securities;
- the potential for increased borrowing costs related to repurchase
agreements;
- interest rate caps related to our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities;
- the overall leverage of our portfolio;
- our ability or inability to use derivatives to mitigate our interest rate
and prepayment risks;
- the impact that increases in interest rates would have on our book value;
- maintaining adequate borrowing capacity so that we can purchase
mortgage-related assets and reach our desired amount of leverage. If we
fail to obtain or renew sufficient funding on favorable terms or at all,
we will be limited in our ability to acquire mortgage-related assets;
- possible market developments could cause our lenders to require us to
pledge additional assets as collateral. If our assets are insufficient to
meet the collateral requirements, we might be compelled to liquidate
particular assets at inopportune times and at disadvantageous prices;
- competition might prevent us from acquiring mortgage-backed securities at
favorable yields, which would harm our results of operations;
52
- if we are disqualified as a REIT, we will be subject to tax as a regular
corporation and face substantial tax liability; and
- complying with REIT requirements might cause us to forego otherwise
attractive opportunities.
Management has established interest rate risk and other policies for
managing the portfolio of mortgage-backed securities and the related borrowings
outstanding. These policies include, but are not limited to, evaluating the
level of risk we assume when purchasing adjustable-rate or hybrid
adjustable-rate mortgage-backed securities which are subject to periodic and
lifetime interest rate caps, matching the interest rates on our assets and
liabilities, acquiring new mortgage-backed securities to replace prepaid
securities, purchasing mortgage-backed securities that we believe to have
favorable-risk adjusted expected returns relative to the market interest rates
at the time of purchase, borrowing between eight and 12 times the amount of our
stockholders' equity, entering into derivative transactions to protect us from
rising interest rates on our repurchase agreements, and monitoring our
qualification as a REIT.
Refer to the section titled "Risk Factors" for additional discussion
regarding these and other risk factors that affect our business. Refer to the
section titled "Quantitative and Qualitative Disclosure About Market
Risk -- Interest Rate Risk" for additional interest rate risk discussion.
CRITICAL ACCOUNTING POLICIES
Our financial statements are prepared in accordance with GAAP. These
accounting principles require us to make some complex and subjective decisions
and assessments. Our most critical accounting policies involve decisions and
assessments that could significantly affect our reported assets and liabilities,
as well as our reported revenues and expenses. We believe that all of the
decisions and assessments upon which our financial statements are based were
reasonable at the time made based upon information available to us at that time.
See Note 2 to the financial statements for a complete discussion of our
significant accounting policies. Management has identified our most critical
accounting policies to be the following:
CLASSIFICATIONS OF INVESTMENT SECURITIES
Our investments in mortgage-backed securities are classified as
available-for-sale securities that are carried on the balance sheet at their
fair value. The classification of the securities as available-for-sale results
in changes in fair value being recorded as adjustments to accumulated other
comprehensive loss, which is a component of stockholders' equity, rather than
immediately through earnings. If available-for-sale securities were classified
as trading securities, there could be substantially greater volatility in
earnings from period-to-period.
VALUATIONS OF MORTGAGE-BACKED SECURITIES
Our mortgage-backed securities have fair values as determined by management
with reference to price estimates provided by independent pricing services and
dealers in the securities. Because the price estimates may vary to some degree
between sources, management must make certain judgments and assumptions about
the appropriate price to use to calculate the fair values for financial
reporting purposes. Different judgments and assumptions could result in
different presentations of value.
When the fair value of an available-for-sale security is less than
amortized cost, management considers whether there is an other-than-temporary
impairment in the value of the security. If, in management's judgment, an
other-than-temporary impairment exists, the cost basis of the security is
written down to the then-current fair value, and the unrealized loss is
transferred from accumulated other comprehensive loss as an immediate reduction
of current earnings (as if the loss had been realized in the period of
impairment). The determination of other-than-temporary impairment is a
subjective process, and different judgments and assumptions could affect the
timing of loss realization.
53
Management considers the following factors when evaluating the securities
for an other-than-temporary impairment:
- The length of the time and the extent to which the market value has been
less than the amortized cost;
- Whether the security has been downgraded by a rating agency; and
- Our intent to hold the security for a period of time sufficient to allow
for any anticipated recovery in market value.
The determination of other-than-temporary impairment is evaluated at least
quarterly. If we determine an impairment to be permanent we may need to realize
a loss that would have an impact on future income.
INTEREST INCOME RECOGNITION
Interest income on our mortgage-backed securities is accrued based on the
actual coupon rate and the outstanding principal amount of the underlying
mortgages. Premiums and discounts are amortized or accreted into interest income
over the lives of the securities using the effective yield method adjusted for
the effects of estimated prepayments based on Statement of Financial Accounting
Standards, or SFAS, No. 91, Accounting for Nonrefundable Fees and Costs
Associated with Originating or Acquiring Loans and Initial Direct Costs of
Leases. If our estimate of prepayments is incorrect, we may be required to make
an adjustment to the amortization or accretion of premiums and discounts that
would have an impact on future income.
ACCOUNTING FOR DERIVATIVE FINANCIAL INSTRUMENTS AND HEDGING ACTIVITIES
Our policies permit us to enter into derivative contracts, including
Eurodollar futures contracts and interest rate swaps, as a means of mitigating
our interest rate risk on forecasted interest expense associated with the
benchmark rate on forecasted rollover/reissuance of repurchase agreements, or
hedged items, for a specified future time period.
At December 31, 2003, we have engaged in short sales of Eurodollar futures
contracts to mitigate our interest rate risk for the specified future time
period, which is defined as the calendar quarter immediately following the
contract expiration date. We sold short 2,090 Eurodollar futures contracts,
which expire in March 2004, June 2004 and September 2004, with a notional amount
totaling $2.1 billion. The value of these futures contracts is marked-to-market
daily in our margin account with the custodian. Based upon the daily market
value of these futures contracts, we either receive funds into, or wire funds
into, our margin account with the custodian to ensure that an appropriate margin
account balance is maintained at all times through the expiration of the
contracts.
These contracts, or hedge instruments, have been designated as cash flow
hedges and are evaluated at inception and on an ongoing basis in order to
determine whether they qualify for hedge accounting under SFAS No. 133, as
amended and interpreted. The hedge instrument must be highly effective in
achieving offsetting changes in the hedged item attributable to the risk being
hedged in order to qualify for hedge accounting. In order to determine whether
the hedge instrument is highly effective, we use regression methodology to
assess the effectiveness of our hedging strategies. Specifically, at the
inception of each new hedge and on an ongoing basis, we assess effectiveness
using "ordinary least squares" regression to evaluate the correlation between
the rates consistent with the hedge instrument and the underlying hedged items.
A hedge instrument is highly effective if the changes in the fair value of the
derivative provide offset of at least 80% and not more than 120% of the changes
in fair value or cash flows of the hedged item attributable to the risk being
hedged. The futures contracts are carried on the balance sheet at fair value.
Any ineffectiveness which arises during the hedging relationship, is recognized
in interest expense during the period in which it arises. Prior to the end of
the specified hedge time period the effective portion of all contract gains and
losses (whether realized or unrealized) is recorded in other comprehensive
income or loss. Realized gains and losses are reclassified into earnings as an
adjustment to interest expense during the
54
specified hedge time period. For REIT taxable net income purposes, realized
gains and losses are reclassified into earnings immediately upon contract
expiration.
We are not required to account for the futures contracts using hedge
accounting as described above. If we decided not to designate the futures
contracts as hedges and to monitor their effectiveness as hedges, or if we
entered into other types of financial instruments that did not meet the criteria
to be designated as hedges, changes in the fair values of these instruments
would affect periodic earnings immediately.
MANAGEMENT INCENTIVE COMPENSATION EXPENSE
The management agreement provides for the payment of incentive compensation
to Seneca if our financial performance exceeds certain benchmarks. Incentive
compensation is calculated on a cumulative, quarterly basis for GAAP purposes
and on a stand-alone quarterly basis with an annual cumulative reconciliation
calculation for incentive compensation payment purposes. During each quarter of
the fiscal year, we will calculate the incentive compensation expense quarterly,
on a cumulative basis, making any necessary adjustments for any expensed amounts
that were recognized in previous quarters. As a result, if we experience poor
quarterly performance in a particular quarter and this causes the cumulative
incentive compensation expense for the current quarter to be lower than the
cumulative incentive compensation for the prior quarter, we will record a
negative incentive compensation expense in the current quarter. The incentive
compensation is payable one-half in cash and one-half in the form of our
restricted common stock.
For the first, second and third quarters of each fiscal year, incentive
compensation payments actually paid to Seneca are calculated based upon the net
income and relevant performance thresholds solely for the applicable quarter,
and a cumulative calculation is performed at the end of the fiscal year. As a
result, during the first three quarters of each fiscal year there will be
differences between incentive compensation expense, for GAAP purposes, and the
incentive compensation amounts actually paid to Seneca. Any differences between
these amounts will be reflected on the balance sheet as a receivable due from or
payable due to Seneca. In addition, when each annual cumulative incentive
compensation calculation and reconciliation is performed, Seneca may be required
to return cash incentive compensation payments earlier received or shares of
common stock earlier granted, as applicable, to it as part of its incentive
compensation payments for the first three quarters of the fiscal year.
The cash portion of the incentive compensation is accrued and expensed
during the period for which it is calculated and paid. We account for the
restricted stock portion of the incentive compensation in accordance with SFAS
No. 123, Accounting for Stock-based Compensation, and related interpretations,
and EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services.
This restricted stock portion of the incentive compensation will be paid or
issued to Seneca on a quarterly basis pursuant to the terms of the management
agreement. The number of shares issued is based on (a) one-half of the total
incentive compensation for the period, divided by (b) the average of the closing
prices of the common stock over the 30 day period ending three days prior to the
grant date, less a fair market value discount determined by our board of
directors to account for the transfer restrictions during the vesting period.
During periods of lower stock prices, we will issue more restricted common stock
to Seneca under the management agreement to pay for the same amount of incentive
compensation earned in periods that had higher stock prices. Over the vesting
period, any additional shares issued would have a dilutive effect on book value
and earnings per share.
On the date of each restricted stock payment or issuance to Seneca under
the management agreement, the fair market value of the common stock shall be
recorded in the stockholders' equity section of our balance sheet as common
stock and additional paid-in capital. The corresponding portion of any
restricted stock payment that is not expensed will be reflected in the
stockholders' equity section of our balance sheet as deferred compensation. Each
quarter's incentive compensation restricted stock payment or issuance to Seneca
will be divided into three tranches. The first tranche will vest over a one-year
period and be expensed over a five-quarter period, beginning in the quarter in
which it was earned. The second
55
tranche will vest over a two-year period and be expensed over a nine-quarter
period beginning in the quarter in which it was earned. The third tranche will
vest over a three-year period and be expensed over a thirteen-quarter period
beginning in the quarter in which it was earned. As a result of this vesting
schedule for the restricted stock issued to Seneca, we will incur incentive
compensation expense in each of the periods following the issuance of the
restricted stock over a three-year period. We will continue to incur incentive
compensation expense related to each restricted stock payment, even in
subsequent periods in which Seneca did not earn incentive compensation under the
management agreement.
As the price of our common stock changes in future periods, the fair value
of the unvested portions of shares paid to Seneca pursuant to the management
agreement shall be marked-to-market, with corresponding entries on the balance
sheet. The net effect of any mark-to-market adjustments to the value of the
unvested portions of the restricted stock shall be expensed in future periods,
on a ratable basis, according to the remaining vesting schedules of each
respective tranche of restricted common stock. Accordingly, incentive
compensation expense related to the portion of the incentive compensation paid
to Seneca in each restricted stock payment or issuance may be higher or lower
from one reporting period to the next, and may vary throughout the vesting
period. For example, future incentive compensation expense related to previously
issued but unvested restricted stock will be higher during periods of increasing
stock prices, and lower during periods of decreasing stock prices. In addition,
over the vesting period for each restricted stock payment or issuance, our
stockholders' equity will increase or decrease based upon the current market
price of our stock. As a result, this will have the effect of increasing or
decreasing our net worth, the factor used in calculating Seneca's base
management fee, and may increase or decrease the amount of base management fees
in future periods.
Pursuant to the management agreement, it is possible for Seneca to earn
incentive compensation each quarter and, as a result, receive a restricted stock
payment each quarter. As Seneca is paid or issued multiple tranches of
restricted common stock for incentive compensation, we will experience
increasing management fee expense due to the cumulative impact of multiple
tranches and vesting schedules of restricted stock payments, and the
mark-to-market impact of the unvested portions of these payments. This will be
true even in periods where there is little change in our income or stock price.
We also pay an incentive fee, in the form of cash and restricted stock, to
our chief financial officer, in accordance with the terms of his employment
agreement. The incentive fee is accounted for in the same manner as the
incentive fee earned by Seneca.
FINANCIAL CONDITION
All of our assets at December 31, 2003 were acquired with the proceeds of
our June 2003 private placement of 11,500,000 shares of our common stock, our
December 2003 initial public offering of 13,110,000 shares of our common stock
and use of leverage. We received net proceeds after offering costs of $159.7
million from the private placement offerings, which closed on June 11, 2003 and
June 19, 2003, and $157.0 million from the initial public offering, which closed
December 24, 2003.
MORTGAGE-BACKED SECURITIES
At December 31, 2003, we held $2.2 billion of mortgage-backed securities at
fair value, net of unrealized gains of $1.1 million and unrealized losses of
$27.4 million. As of December 31, 2003, all of the mortgage-backed securities in
our portfolio were purchased at a premium to their par value and our portfolio
had a weighted-average amortized cost of 102.2% of face amount.
Certain of the securities held at December 31, 2003 are impaired as the
fair value of the securities is below amortized cost. At December 31, 2003, our
entire portfolio was invested in AAA-rated non-agency-backed or agency-backed
mortgage-backed securities. None of the securities held had been downgraded by a
credit rating agency since their purchase. In addition, we intend to hold the
securities until maturity, allowing for the anticipated recovery in fair value
of the securities held. As such, we do not believe any of securities held are
other-than-temporarily impaired at December 31, 2003.
56
The stated contractual final maturity of the mortgage loans underlying our
portfolio of mortgage-backed securities ranges up to 30 years, however, the
expected maturity is subject to change based on the prepayments of the
underlying mortgage loans. The following table sets forth the maturity dates, by
year, and percentage composition related to the assets that comprise our
investment portfolio as of December 31, 2003:
AVERAGE FINAL
ASSET MATURITY % OF TOTAL
----- ------------- ----------
Adjustable-Rate Mortgage-Backed Securities.................. 2033 8.6%
Hybrid Adjustable-Rate Mortgage-Backed Securities........... 2033 88.9%
Balloon Mortgage-Backed Securities.......................... 2008 2.5%
Fixed-Rate Mortgage-Backed Securities....................... N/A N/A
Actual maturities of mortgage-backed securities are generally shorter than
stated contractual maturities. Actual maturities of our mortgage-backed
securities are affected by the contractual lives of the underlying mortgages,
periodic payments of principal, and prepayments of principal.
The constant prepayment rate, or CPR, on our mortgage-backed securities for
the quarter ended December 31, 2003 was 23%. CPR attempts to predict the
percentage of principal that will prepay over the next 12 months based on
historical principal paydowns. As interest rates have risen, the rate of
refinancings has declined, which we believe may result in lower rates of
prepayments and, as a result, a lower portfolio CPR.
As of December 31, 2003, the weighted-average effective duration of the
securities in our overall investment portfolio, assuming constant prepayment
rates to the balloon or reset date, or the CPB duration, was 1.75 years. CPB is
similar to CPR except that it also assumes that the hybrid adjustable-rate
mortgage-backed securities prepay in full at their next reset date. As of
December 31, 2003, the mortgages underlying our hybrid adjustable-rate
mortgage-backed securities had fixed interest rates for a weighted-average of
approximately 43 months, after which time the interest rates reset and become
adjustable. The average length of time until maturity of those mortgages was 30
years. Those mortgages are also subject to interest rate caps that limit the
amount that the applicable interest rate can increase during any year, known as
an annual cap, and through the maturity of the applicable security, known as a
lifetime cap. As of December 31, 2003, the mortgages underlying our hybrid
adjustable-rate mortgage-backed securities had average annual caps of 2.47% and
average lifetime caps of 10.03%.
The following table summarizes our mortgage-backed securities on December
31, 2003 according to their estimated weighted-average life classifications:
WEIGHTED-AVERAGE
WEIGHTED-AVERAGE LIFE FAIR VALUE AMORTIZED COST COUPON
--------------------- -------------- -------------- ----------------
(IN THOUSANDS) (IN THOUSANDS)
Less than one year........................ $ 299,685 $ 304,556 4.07%
Greater than one year and less than five
years................................... 1,829,471 1,850,899 4.09
Greater than five years................... 32,789 32,843 3.96
---------- ----------
Total..................................... $2,161,945 $2,188,298 4.09%
========== ==========
The weighted-average lives of the mortgage-backed securities at December
31, 2003 in the table above are based upon data provided through a
subscription-based financial information service provided by a major investment
bank, assuming constant principal prepayment rates to the balloon or reset date
for each security. At December 31, 2003, the weighted-average lives were
calculated using estimated prepayment speeds or actual prepayment speed history.
The weighted-average lives for some of the mortgage-backed securities included
in the table above were estimated using expected prepayment speeds for pools,
since certain pools were new issues and did not have historical performance data
available. The prepayment model considers current yield, forward yield,
steepness of the yield curve, current mortgage rates, mortgage rate of the
outstanding loan, loan age, margin and volatility.
57
The actual weighted-average lives of the mortgage-backed securities in our
investment portfolio could be longer or shorter than the estimates in the tables
above depending on the actual prepayment rates experienced over the life of the
applicable securities and is sensitive to changes in both prepayment rates and
interest rates.
EQUITY SECURITIES
Our investment policies allow us to acquire a limited amount of equity
securities, including common and preferred shares issued by other real estate
investment trusts. At December 31, 2003, we did not hold any equity securities.
UNSETTLED SECURITIES PURCHASES
At December 31, 2003, we had unsettled securities purchases of $156.1
million which subsequently settled in January 2004. Of the $156.1 million of
unsettled securities purchases, $59.8 million are related to "to be announced,"
or TBA, mortgage-backed securities.
OTHER ASSETS
We had other assets of $10.2 million at December 31, 2003. Other assets
consist primarily of interest receivable of $7.3 million and principal
receivable of $2.3 million.
HEDGING INSTRUMENTS
There can be no assurance that our hedging activities will have the desired
beneficial impact on our results of operations or financial condition. Moreover,
no hedging activity can completely insulate us from the risks associated with
changes in interest rates and prepayment rates.
Hedging involves risk and typically involves costs, including transaction
costs. The costs of hedging increase dramatically as the period covered by the
hedging increases and during periods of rising and volatile interest rates. We
may increase our hedging activity and, thus, increase our hedging costs during
such periods when interest rates are volatile or rising. We generally intend to
hedge as much of the interest rate risk as our manager determines is in the best
interest of our stockholders, after considering the cost of such hedging
transactions and our desire to maintain our status as a REIT. Our policies do
not contain specific requirements as to the percentages or amount of interest
rate risk that our manager is required to hedge.
At December 31, 2003, we have engaged in short sales of Eurodollar futures
contracts as a means of mitigating our interest rate risk on forecasted interest
expense associated with the benchmark rate on forecasted rollover/reissuance of
repurchase agreements, or hedged item, for a specified future time period, which
is defined as the calendar quarter immediately following the contract expiration
date. We sold short 2,090 Eurodollar futures contracts, which expire in March
2004, June 2004 and September 2004, with a notional amount totaling $2.1
billion. The value of these futures contracts is marked-to-market daily in our
margin account with the custodian. Based upon the daily market value of these
futures contracts, we either receive funds into, or wire funds into, our margin
account with the custodian to ensure that an appropriate margin account balance
is maintained at all times through the expiration of the contracts. At December
31, 2003, the unrealized loss on the Eurodollar futures contracts was $157
thousand.
LIABILITIES
We have entered into repurchase agreements to finance some of our
acquisitions of mortgage-backed securities. None of the counterparties to these
agreements are affiliates of Seneca or us. These agreements are secured by our
mortgage-backed securities and bear interest rates that have historically moved
in close relationship to LIBOR. As of December 31, 2003, we had established 17
borrowing arrangements with various investment banking firms and other lenders,
12 of which were in use on December 31, 2003.
58
At December 31, 2003, we had outstanding $1.7 billion of repurchase
agreements with a weighted-average current borrowing rate of 1.19%, $337.3
million of which matures within 30 days, $281.9 million of which matures between
31 and 90 days and $1.1 billion of which matures in greater than 90 days. It is
our present intention to seek to renew these repurchase agreements as they
mature under the then-applicable borrowing terms of the counterparties to our
repurchase agreements. At December 31, 2003, the repurchase agreements were
secured by mortgage-backed securities with an estimated fair value of $1.8
billion and had a weighted-average maturity of 145 days. The net amount at risk,
defined as fair value of securities sold, plus accrued interest income, minus
repurchase agreement liabilities, plus accrued interest expense, with all
counterparties was $83.2 million.
After consideration of the duration on our Eurodollar futures contracts,
our weighted-average maturity of our total liabilities was 255 days.
We had $167.9 million of other liabilities at December 31, 2003. Other
liabilities consisted primarily of $156.1 million of unsettled securities
purchases, $5.3 million of cash distribution payable, $3.8 million of accrued
interest expense on repurchase agreements, $1.4 million of accounts payable and
accrued expenses, and $1.1 million of management fee payable, incentive fee
payable and other related party liabilities.
We have a margin lending facility with our primary custodian from which we
may borrow money in connection with the purchase or sale of securities. The
terms of the borrowings, including the rate of interest payable, are agreed to
with the custodian for each amount borrowed. Borrowings are repayable
immediately upon demand of the custodian. At December 31, 2003, there were no
outstanding borrowings under the margin lending facility.
STOCKHOLDERS' EQUITY
Stockholders' equity at December 31, 2003 was $282.5 million and included
$26.3 million of unrealized losses on mortgage-backed securities
available-for-sale and $157 thousand of unrealized losses on cash flow hedges
presented as accumulated other comprehensive loss.
Average stockholders' equity for the period from June 11, 2003,
commencement of operations, through December 31, 2003 was $128.4 million. Return
on average equity was 3.85% for the period from June 11, 2003, commencement of
operations, through December 31, 2003. Because of the timing of our initial
investment of portfolio assets (investment activities began on June 11, 2003,
the first security purchase settled on June 16, 2003, and the remainder settled
through July 31, 2003), interest income for the period from June 11, 2003
through December 31, 2003 was lower than would be expected for a typical full
period, both in an absolute sense and also relative to the average net invested
assets for the period. During the period, the U.S. bond markets also experienced
dramatic price and yield volatility. Increasing interest rates caused the
overall market value of our portfolio to decrease, and our leverage, defined as
our total debt divided by stockholders' equity, to increase beyond our desired
range. In order to deleverage our portfolio we sold securities at a loss. In
addition, operating expenses were high in proportion to gross interest income
and expense and to net interest income as compared to expectations for full
periods of operations because of the costs of start-up operations. As such,
return on average equity was lower as compared to expectations for full periods
of operations.
Our book value at December 31, 2003 was as follows:
TOTAL STOCKHOLDERS' BOOK VALUE PER
EQUITY SHARE(1)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) ------------------- --------------
Total stockholders' equity............................ $282,496 $11.38
Accumulated other comprehensive loss on
mortgage-backed securities.......................... 26,353 1.07
-------- ------
Total stockholders' equity, excluding accumulated
other comprehensive loss on mortgage-backed
securities.......................................... $308,849 $12.45
======== ======
---------------
(1) Based on 24,814,000 shares outstanding on December 31, 2003
59
Management believes that total stockholders' equity excluding accumulated
other comprehensive loss on mortgage-backed securities is a useful measure to
investors because book value unadjusted for temporary declines in the fair
values of securities more closely represents the cost basis of our invested
assets, net of our leverage, which is the basis for our net interest income and
our distributions to stockholders under the provisions of the Internal Revenue
Code governing REIT distributions.
RESULTS OF OPERATIONS
For the period from April 26, 2003 through December 31, 2003, net income
was $2.8 million, or $0.27 per weighted-average share outstanding (basic and
diluted). For the same period, interest income, net of premium amortization, was
approximately $22.6 million, and was primarily earned from investments in
mortgage-backed securities. Interest expense on short-term borrowings was $9.0
million. Because of the timing of our initial investment of portfolio assets
(investment activities began on June 11, 2003), interest income for the period
from April 26, 2003 through December 31, 2003 was substantially lower than would
be expected for a typical full period, both in an absolute sense and also
relative to the average net invested assets for the period. In addition,
prepayment activity declined due to the changing interest rate environment and
resulted in decreased premium amortization and increased yield on average
earning assets.
For the quarter ended December 31, 2003, the weighted-average yield on
average earning assets, net of amortization of premium was 2.81% and the
weighted-average interest rate on our repurchase agreement liabilities was 1.20%
resulting in a net interest margin of 1.61%. Our net interest margin improved
during the course of the fourth quarter. For the period from April 26, 2003
through December 31, 2003, net interest margin and its components are not
meaningful due to the timing of our initial investments and related borrowings.
Included in net income for the period from April 26, 2003 through December
31, 2003 are net losses on sales of mortgage-backed securities of $7.8 million
which occurred during the quarter ended September 30, 2003. Between June 30,
2003 and mid-August 2003, the U.S. bond markets experienced dramatic price and
yield volatility. Increasing interest rates caused the overall market value of
our portfolio to decrease and our leverage (defined as our total debt divided by
stockholders' equity) to increase beyond management's desired range. To reduce
leverage, we sold securities in mid-August totaling $130.7 million and realized
a loss of $2.3 million. In an attempt to protect our portfolio from further
increases in interest rates, we sold short $200 million of TBA mortgage
securities. Interest rates subsequently declined, and we closed out this short
position in the month of September for a total realized loss of $5.7 million.
During the third quarter, we also simultaneously sold and purchased securities
totaling $215.9 million and $215.7 million, respectively, that resulted in a
realized gain on sale of $0.2 million. We did not sell any mortgage-backed
securities during the period from April 26 through June 30, 2003 or during the
quarter ended December 31, 2003, therefore, there were no gains or losses on
sales of securities for these periods. Although we generally intend to hold our
investment securities to maturity, Seneca may determine at some time before they
mature that it is in our interest to sell them and purchase securities with
other characteristics. In that event, our earnings will be affected by realized
gains or losses.
Operating expenses for the period from April 26, 2003 through December 31,
2003 were $3.1 million. Operating expenses were high in proportion to gross
interest income and expense and to net interest income as compared to
expectations for full periods of operations because of the costs of start-up
operations.
Base management fees to Seneca under the management agreement, which were
$901 thousand for the period from April 26, 2003 through December 31, 2003, are
based on a percentage of our average net worth. "Average net worth" for these
purposes is calculated on a monthly basis and equals the difference between the
aggregate book value of our consolidated assets prior to accumulated
depreciation and other non-cash items, including the fair market value
adjustment on mortgage-backed securities, minus the aggregate book value of our
consolidated liabilities.
60
Incentive fee expense to related parties for the period from April 26, 2003
through December 31, 2003 was $980 thousand. Incentive compensation is earned by
related parties when REIT taxable net income (before deducting incentive
compensation, net operating losses and certain other items) relative to the
average net invested assets for the period, as defined in the management
agreement, exceeds the "threshold return" taxable income that would have
produced an annualized return on equity equal to the sum of the 10-year U.S.
Treasury rate plus 2.0% for the same period. REIT taxable net income (before
deducting incentive compensation, net operating losses and certain other items)
for the period from April 26, 2003 through December 31, 2003 was $11.7 million
and was greater than the "threshold return" taxable income of $5.6 million for
the same period. Incentive compensation earned by Seneca during the period from
April 26, 2003 through December 31, 2003 was $1.2 million, of which $613
thousand was waived by Seneca for the quarter ended September 30, 2003.
For the quarter ended December 31, 2003, total incentive compensation
expense to Seneca was $606 thousand, one-half payable in cash and one-half
payable in the form of shares of our common stock as described above. The cash
portion of the incentive fee of $303 thousand for the quarter ended December 31,
2003 was expensed in that period as well as 15.2% of the restricted stock
portion of the incentive fees, or $46 thousand. The remaining incentive fee for
the quarter ended December 31, 2003 of $30 thousand was earned by our chief
financial officer, in accordance with the terms of his employment agreement.
This portion of the incentive fee is also payable one-half in cash and one-half
in the form of a restricted stock award under our 2003 stock incentive plan. The
shares are payable and vest over the same vesting schedule as the stock issued
to Seneca. The cash portion of the incentive fee of $15 thousand for the quarter
ended December 31, 2003 was expensed in that period as well as 15.2% of the
restricted stock portion of the incentive fees, or $3 thousand.
We did not pay incentive compensation to Seneca for the quarter ended
September 30, 2003 or the period from April 26, 2003 to June 30, 2003. The
incentive compensation expense earned by Seneca for the quarter ended September
30, 2003 of $613 thousand was waived by Seneca on a one-time basis only due to
the net loss we reported during that same period. The waived incentive fee was
accounted for as incentive fee expense and a capital contribution as of
September 30, 2003. We do not expect Seneca to waive incentive compensation in
the future. REIT taxable net income (before deducting incentive compensation,
net operating losses and certain other items) for the period from April 26, 2003
through June 30, 2003, was $298 and was less than the "threshold return" taxable
income of $426 and, therefore, no incentive fee was earned by Seneca or paid by
us. No incentive compensation was earned or paid to our chief financial officer
for the period from April 26, 2003 to September 30, 2003.
Professional services expense for the period from April 26, 2003 through
December 31, 2003 of $477 thousand includes both legal and accounting services
provided to us. We experienced relatively higher levels of professional service
expenses during our stabilization period as a public company. Included in this
balance are organization costs of $163 thousand, and costs related to the filing
of our resale shelf registration statement totaling $44 thousand. The insurance
expense for the same period of $291 thousand represents amortization of prepaid
directors' and officers' insurance. Custody expense of $115 thousand for the
period from April 26, 2003 through December 31, 2003 includes the services
provided by our primary custodian. These expenses may vary based on levels of
activity within the portfolio. Included in the other general and administrative
expenses of $73 thousand for the period from April 26, 2003 through December 31,
2003 are costs related to the filing of our resale shelf registration statement
totaling $27 thousand.
61
REIT taxable net income is calculated according to the requirements of the
Internal Revenue Code, rather than GAAP. The following table reconciles GAAP net
income to REIT taxable net income for the period from April 26, 2003 through
December 31, 2003 (in thousands):
GAAP net income............................................. $ 2,761
Adjustments to GAAP net income:
Addback of organizational costs expensed during the
period................................................. 163
Amortization of organizational costs for tax purposes..... (18)
Addback of net capital losses in the period............... 7,831
Addback waived incentive fee for the quarter ended
September 30, 2003..................................... 613
Addback of stock compensation expense for incentive fee... 48
Addback of stock compensation expense for unvested
options................................................ 3
-------
Net adjustments to GAAP net income..................... 8,640
-------
REIT taxable net income..................................... $11,401
=======
We believe that the presentation of our REIT taxable net income is useful
to investors because it is directly related to the distributions we are required
to make in order to retain our REIT status and to the calculations of the
incentive compensation payable to related parties (before deducting incentive
compensation, net operating losses and certain other items). There are
limitations associated with REIT taxable net income. For example, this measure
does not reflect net capital losses during the period and, thus, by itself is an
incomplete measure of our financial performance over any period. As a result,
our REIT taxable net income should be considered in addition to, and not as a
substitute for, our GAAP-based net income as a measure of our financial
performance.
CONTRACTUAL OBLIGATIONS AND COMMITMENTS
As of December 31, 2003, we had entered into a management agreement with
our Manager. See Note 7 to the financial statements for significant terms of the
management agreement.
OFF-BALANCE SHEET ARRANGEMENTS
Since inception, we have not maintained any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, established for
the purpose of facilitating off-balance sheet arrangements or other
contractually narrow or limited purposes. Further, we have not guaranteed any
obligations of unconsolidated entities nor do we have any commitment or intent
to provide additional funding to any such entities. Accordingly, we are not
materially exposed to any market, credit, liquidity or financing risk that could
arise if we had engaged in such relationships.
LIQUIDITY AND CAPITAL RESOURCES
Our primary source of funds as of December 31, 2003 consisted of repurchase
agreements totaling $1.7 billion with a weighted-average current borrowing rate
of 1.19% which we used to finance acquisition of mortgage-related assets. We
expect to continue to borrow funds in the form of repurchase agreements. As of
December 31, 2003 we had established 17 borrowing arrangements with various
investment banking firms and other lenders, 12 of which were in use on December
31, 2003. Increases in short-term interest rates could negatively impact the
valuation of our mortgage-related assets, which could limit our borrowing
ability or cause our lenders to initiate margin calls. Amounts due upon maturity
of our repurchase agreements will be funded primarily through the
rollover/reissuance of repurchase agreements and monthly principal and interest
payments received on our mortgage-backed securities. We generally seek to borrow
between eight and 12 times the amount of our equity. Our leverage ratio at
December 31, 2003 was 6.1. At December 31, 2003, substantially all of the net
offering proceeds from our initial public offering had been used to purchase
mortgage-backed securities. However, at December 31, 2003, we had not fully
62
levered our portfolio to within our target range of eight to 12 times the amount
of our equity. As a result, the total amount of mortgage-backed securities and
repurchase agreement liabilities as of December 31, 2003 were lower than they
will be once our portfolio is fully levered through additional repurchase
agreement liabilities and related mortgage-backed security purchases.
We have a margin lending facility with our primary custodian from which we
may borrow money in connection with the purchase or sale of securities. The
terms of the borrowings, including the rate of interest payable, are agreed to
with the custodian for each amount borrowed. Borrowings are repayable
immediately upon demand of the custodian. At December 31, 2003, there were no
outstanding borrowings under the margin lending facility.
For liquidity, we also rely on the cash flow from operations, primarily
monthly principal and interest payments to be received on our mortgage-backed
securities, as well as any primary securities offerings authorized by our board
of directors.
On November 17, 2003, we paid a cash distribution of $0.50 per share to our
stockholders of record on October 21, 2003. On January 28, 2004, we paid a cash
distribution of $0.45 per share to our stockholders of record on December 11,
2003. Both of these distributions are taxable dividends, and neither of these
distributions are considered return of capital. The distributions were funded
with cash flow from our ongoing operations, including principal and interest
payments received on our mortgage-backed securities. We did not distribute $282
thousand of our REIT taxable net income for the period from April 26, 2003
through December 31, 2003. We intend to declare a spillback distribution in this
amount during 2004.
We believe that equity capital, combined with the cash flow from operations
and the utilization of borrowings, will be sufficient to enable us to meet
anticipated liquidity requirements. However, an increase in prepayment rates
substantially above our expectations could cause a liquidity shortfall. If our
cash resources are at any time insufficient to satisfy our liquidity
requirements, we may be required to liquidate mortgage-backed securities or sell
debt or additional equity securities. If required, the sale of mortgage-backed
securities at prices lower than the carrying value of such assets would result
in losses and reduced income.
We intend to increase our capital resources by making additional offerings
of equity and debt securities, possibly including classes of preferred stock,
common stock, commercial paper, medium-term notes, collateralized mortgage
obligations and senior or subordinated notes. Such financing will depend on
market conditions for capital raises and for the investment of any proceeds. All
debt securities, other borrowings, and classes of preferred stock will be senior
to the common stock in a liquidation of our company.
INFLATION
Virtually all of our assets and liabilities are financial in nature. As a
result, interest rates and other factors influence our performance far more so
than does inflation. Changes in interest rates do not necessarily correlate with
inflation rates or changes in inflation rates. Our financial statements are
prepared in accordance with accounting principles generally accepted in the
United States and our distributions are determined by our board of directors
based primarily by our net income as calculated for tax purposes; in each case,
our activities and balance sheet are measured with reference to historical cost
and or fair market value without considering inflation.
63
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our primary component of market risk is interest rate risk, as described
below. While we do not seek to avoid risk completely, we do seek to assume risk
that can be quantified from historical experience, to actively manage that risk,
to earn sufficient compensation to justify taking those risks and to maintain
capital levels consistent with the risks we undertake.
INTEREST RATE RISK
We are subject to interest rate risk in connection with our investments in
fixed-rate, adjustable-rate and hybrid adjustable-rate mortgage-backed
securities and our related debt obligations, which are generally repurchase
agreements of limited duration that are periodically refinanced at current
market rates, and our derivative contracts.
EFFECT ON NET INTEREST INCOME
We fund our investments in some long-term, fixed-rate and hybrid
adjustable-rate mortgage-backed securities with short-term borrowings under
repurchase agreements. During periods of rising interest rates, the borrowing
costs associated with those fixed-rate and hybrid-adjustable rate
mortgage-backed securities tend to increase while the income earned on such
fixed-rate and hybrid adjustable-rate mortgage-backed securities (during the
fixed-rate component of such securities) may remain substantially unchanged.
This results in a narrowing of the net interest spread between the related
assets and borrowings and may even result in losses.
As a means to mitigate the negative impact of a rising interest rate
environment, we have entered into derivative transactions, specifically
Eurodollar futures contracts. As of December 31, 2003, we sold short 2,090
Eurodollar futures contracts in order to hedge the impact of changes in interest
rates on our liability costs. The following table summarizes the expiration
dates of these Eurodollar futures contracts and their notional amounts (in
thousands):
NOTIONAL
EXPIRATION DATE AMOUNT
--------------- ---------------
March 2004.................................................. $ 880,000
June 2004................................................... 605,000
September 2004.............................................. 605,000
----------
Total....................................................... $2,090,000
==========
Subsequent to December 31, 2003 through March 29, 2004, we have sold short
an additional 4,470 Eurodollar futures contracts. These contracts expire in June
2004, September 2004 and December 2004 and have a notional amount totaling $2.0
billion, $1.6 billion and $840.0 million, respectively. In addition, we realized
$416 thousand in losses subsequent to December 31, 2003 through March 29, 2004
upon expiration or closeout of our March 2004 Eurodollar futures contracts.
Hedging techniques are based, in part, on assumed levels of prepayments of
our fixed-rate and hybrid adjustable-rate mortgage-backed securities. If
prepayments are slower or faster than assumed, the life of the mortgage-backed
securities will be longer or shorter which would reduce the effectiveness of any
hedging strategies we may utilize and may result in losses on such transactions.
Hedging strategies involving the use of derivative securities are highly complex
and may produce volatile returns. Our hedging activity will also be limited by
the asset and sources-of-income requirements applicable to us as a REIT.
EXTENSION RISK
We invest in fixed-rate and hybrid adjustable-rate mortgage-backed
securities. Hybrid adjustable-rate mortgage-backed securities have interest
rates that are fixed for the first few years of the loan -- typically three,
five, seven or 10 years -- and thereafter their interest rates reset
periodically on the same basis as adjustable-rate mortgage-backed securities. As
of December 31, 2003, 88.9% of our investment portfolio
64
was comprised of hybrid adjustable-rate mortgage-backed securities. We compute
the projected weighted-average life of our fixed-rate and hybrid adjustable-rate
mortgage-backed securities based on the market's assumptions regarding the rate
at which the borrowers will prepay the underlying mortgages. In general, when a
fixed-rate or hybrid adjustable-rate mortgage-backed security is acquired with
borrowings, we may, but are not required to, enter into an interest rate swap
agreement or other hedging instrument that effectively fixes our borrowing costs
for a period close to the anticipated average life of the fixed-rate portion of
the related mortgage-backed security. This strategy is designed to protect us
from rising interest rates because the borrowing costs are fixed for the
duration of the fixed-rate portion of the related mortgage-backed security.
However, if prepayment rates decrease in a rising interest rate environment, the
life of the fixed-rate portion of the related mortgage-backed security could
extend beyond the term of the swap agreement or other hedging instrument. This
situation could negatively impact us as borrowing costs would no longer be fixed
after the end of the hedging instrument while the income earned on the fixed-
rate or hybrid adjustable-rate mortgage-backed security would remain fixed. This
situation may also cause the market value of our fixed-rate and hybrid
adjustable-rate mortgage-backed securities to decline with little or no
offsetting gain from the related hedging transactions. In extreme situations, we
may be forced to sell assets and incur losses to maintain adequate liquidity.
ADJUSTABLE-RATE AND HYBRID ADJUSTABLE-RATE MORTGAGE-BACKED SECURITY INTEREST
RATE CAP RISK
We also invest in adjustable-rate and hybrid adjustable-rate
mortgage-backed securities which are based on mortgages that are typically
subject to periodic and lifetime interest rate caps and floors, which limit the
amount by which an adjustable-rate or hybrid adjustable-rate mortgage-backed
security's interest yield may change during any given period. However, our
borrowing costs pursuant to our repurchase agreements will not be subject to
similar restrictions. Therefore, in a period of increasing interest rates,
interest rate costs on our borrowings could increase without limitation by caps,
while the interest-rate yields on our adjustable-rate and hybrid adjustable-rate
mortgage-backed securities would effectively be limited by caps. This problem
will be magnified to the extent we acquire adjustable-rate and hybrid
adjustable-rate mortgage-backed securities that are not based on mortgages which
are fully-indexed. In addition, the underlying mortgages may be subject to
periodic payment caps that result in some portion of the interest being deferred
and added to the principal outstanding. This could result in our receipt of less
cash income on our adjustable-rate and hybrid adjustable-rate mortgage-backed
securities than we need in order to pay the interest cost on our related
borrowings. These factors could lower our net interest income or cause a net
loss during periods of rising interest rates, which would negatively impact our
financial condition, cash flows and results of operations.
INTEREST RATE MISMATCH RISK
We intend to fund a substantial portion of our acquisitions of
adjustable-rate and hybrid adjustable-rate mortgage-backed securities with
borrowings that have interest rates based on indices and repricing terms similar
to, but of somewhat shorter maturities than, the interest rate indices and
repricing terms of the mortgage-backed securities. Thus, we anticipate that in
most cases the interest rate indices and repricing terms of our mortgage assets
and our funding sources will not be identical, thereby creating an interest rate
mismatch between assets and liabilities. Therefore, our cost of funds would
likely rise or fall more quickly than would our earnings rate on assets. During
periods of changing interest rates, such interest rate mismatches could
negatively impact our financial condition, cash flows and results of operations.
To mitigate interest rate mismatches, we may utilize hedging strategies
discussed above and in Note 12 to the financial statements.
Our analysis of risks is based on management's experience, estimates,
models and assumptions. These analyses rely on models which utilize estimates of
fair value and interest rate sensitivity. Actual economic conditions or
implementation of investment decisions by our management may produce results
that differ significantly from the estimates and assumptions used in our models
and the projected results shown in this prospectus.
65
PREPAYMENT RISK
Prepayments are the full or partial repayment of principal prior to the
original term to maturity of a mortgage loan and typically occur due to
refinancing of mortgage loans. Prepayment rates for existing mortgage-backed
securities generally increase when prevailing interest rates fall below the
market rate existing when the underlying mortgages were originated. In addition,
prepayment rates on adjustable-rate and hybrid adjustable-rate mortgage-backed
securities generally increase when the difference between long-term and
short-term interest rates declines or becomes negative. Prepayments of
mortgage-backed securities could harm our results of operations in several ways.
Some adjustable-rate mortgages underlying our adjustable-rate mortgage-backed
securities may bear initial "teaser" interest rates that are lower than their
"fully-indexed" rates, which refers to the applicable index rates plus a margin.
In the event that such an adjustable-rate mortgage is prepaid prior to or soon
after the time of adjustment to a fully-indexed rate, the holder of the related
mortgage-backed security would have held such security while it was less
profitable and lost the opportunity to receive interest at the fully-indexed
rate over the expected life of the adjustable-rate mortgage-backed security.
Although we currently do not own any adjustable-rate mortgage-backed securities
with "teaser" rates, we may obtain some in the future which would expose us to
this prepayment risk. Additionally, we currently own mortgage-backed securities
that were purchased at a premium. The prepayment of such mortgage-backed
securities at a rate faster than anticipated would result in a write-off of any
remaining capitalized premium amount and a consequent reduction of our net
interest income by such amount. Finally, in the event that we are unable to
acquire new mortgage-backed securities to replace the prepaid mortgage-backed
securities, our financial condition, cash flow and results of operations could
be negatively impacted.
EFFECT ON FAIR VALUE
Another component of interest rate risk is the effect changes in interest
rates will have on the market value of our assets. We face the risk that the
market value of our assets will increase or decrease at different rates than
that of our liabilities, including our hedging instruments.
We primarily assess our interest rate risk by estimating the duration of
our assets and the duration of our liabilities. Duration essentially measures
the market price volatility of financial instruments as interest rates change.
We generally calculate duration using various financial models and empirical
data. Different models and methodologies can produce different duration numbers
for the same securities.
66
The following sensitivity analysis table shows the estimated impact on the
fair value of our interest rate-sensitive investments and repurchase agreement
liabilities, at December 31, 2003, assuming rates instantaneously fall 100 basis
points, rise 100 basis points and rise 200 basis points:
INTEREST RATES INTEREST RATES INTEREST RATES
FALL 100 RISE 100 RISE 200
BASIS POINTS UNCHANGED BASIS POINTS BASIS POINTS
-------------- --------- -------------- --------------
(DOLLARS IN MILLIONS)
ADJUSTABLE-RATE MORTGAGE-BACKED
SECURITIES
Fair value............................. $ 187.8 $ 185.3 $ 184.2 $ 181.4
Change in fair value................... $ 2.5 -- $ (1.1) $ (3.9)
Change as a percent of fair value...... 1.3% -- (0.6)% (2.1)%
HYBRID ADJUSTABLE-RATE MORTGAGE-BACKED
SECURITIES
Fair value............................. $1,954.4 $1,921.9 $1,890.8 $1,851.2
Change in fair value................... $ 32.4 -- $ (31.2) $ (70.8)
Change as a percent of fair value...... 1.7% -- (1.7)% (3.8)%
BALLOON MORTGAGE-BACKED SECURITIES
Fair value............................. $ 56.1 $ 54.7 $ 52.8 $ 53.0
Change in fair value................... $ 1.4 -- $ (1.9) $ (1.7)
Change as a percent of fair value...... 2.5% -- (3.6)% (3.2)%
TOTAL MORTGAGE-BACKED SECURITIES
Fair value............................. $2,198.3 $2,161.9 $2,127.8 $2,085.6
Change in fair value................... $ 36.3 -- $ (34.2) $ (76.4)
Change as a percent of fair value...... 1.7% -- (1.6)% (3.7)%
REPURCHASE AGREEMENTS (1)
Fair value............................. $1,729.0 $1,729.0 $1,729.0 $1,729.0
Change in fair value................... -- -- -- --
Change as a percent of fair value...... -- -- -- --
HEDGE INSTRUMENTS
Fair value............................. $ (5.4) $ (0.2) $ 5.1 $ 10.3
Change in fair value................... $ (5.2) -- $ 5.3 $ 10.5
Change as a percent of fair value...... n/m -- n/m n/m
---------------
(1) The fair value of the repurchase agreements would not change materially due
to the short-term nature of these instruments.
n/m = not meaningful
It is important to note that the impact of changing interest rates on fair
value can change significantly when interest rates change beyond 100 basis
points from current levels. Therefore, the volatility in the fair value of our
assets could increase significantly when interest rates change beyond 100 basis
points. In addition, other factors impact the fair value of our interest
rate-sensitive investments and hedging instruments, such as the shape of the
yield curve, market expectations as to future interest rate changes and other
market conditions. Accordingly, in the event of changes in actual interest
rates, the change in the fair value of our assets would likely differ from that
shown above, and such difference might be material and adverse to our
stockholders.
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RISK MANAGEMENT
To the extent consistent with maintaining our REIT status, we seek to
manage our interest rate risk exposure to protect our portfolio of
mortgage-backed securities and related debt against the effects of major
interest rate changes. We generally seek to manage our interest rate risk by:
- monitoring and adjusting, if necessary, the reset index and interest rate
related to our mortgage-backed securities and our borrowings;
- attempting to structure our borrowing agreements to have a range of
different maturities, terms, amortizations and interest rate adjustment
periods;
- using derivatives, financial futures, swaps, options, caps, floors and
forward sales, to adjust the interest rate sensitivity of our
mortgage-backed securities and our borrowings; and
- actively managing, on an aggregate basis, the interest rate indices,
interest rate adjustment periods, and gross reset margins of our
mortgage-backed securities and the interest rate indices and adjustment
periods of our borrowings.
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CONFLICTS OF INTERESTS; CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In evaluating mortgage-related assets for investment and in other operating
strategies, an undue emphasis by Seneca on the maximization of income at the
expense of other criteria, such as preservation of capital, in order to earn
higher incentive compensation for Seneca under the management agreement could
result in an increased risk to the value of our portfolio. Any changes in our
investment and operating policies are required to be approved by our board of
directors. See "The Manager -- The Management Agreement."
Two of our directors and four of our executive officers, including our
chairman of the board, chief executive officer and president, are affiliated
with Seneca. We, on the one hand, and Seneca and its affiliates, on the other
hand, may in the future enter into a number of relationships other than those
governed by the management agreement, some of which may give rise to conflicts
of interest between us and Seneca or its affiliates. For instance, we have
entered into a cost-sharing agreement with Seneca regarding overhead items such
as space, utilities and other administrative services. See "The Manager -- The
Cost-Sharing Agreement." In addition, the market in which we seek to purchase
mortgage-related assets is characterized by rapid evolution of products and
services and, thus, there may in the future be relationships between us and
Seneca and its affiliates in addition to those described herein. Under the
management agreement, the prior approval of a majority of our independent
directors is required for each affiliate transaction between Seneca or its
affiliates and us; provided, however, that a majority of the independent
directors may approve guidelines for affiliate transactions that would permit
most affiliate transactions to be closed without prior board approval in each
instance. In addition, Seneca will be required to provide to our board on a
quarterly basis a report of such transactions, including evidence sufficient to
allow our board of directors to determine whether the terms of such transactions
are fair.
Seneca has informed us that it expects to continue to, or may in the
future, purchase and manage mortgage-related assets and other real
estate-related assets for third-party accounts. In addition, Seneca and its
affiliates may from time to time purchase mortgage-related assets for their own
account. Seneca and its affiliates will have no obligation to make any
particular investment opportunities available to us; provided, however, that if
Seneca intends to invest in residential mortgage-backed securities entirely for
its own account (as distinct from its clients' accounts), it is required to
present the opportunity to us first. As a result, there may be a conflict of
interest between the operations of Seneca and its affiliates, on the one hand,
and our company, on the other hand, in the acquisition and disposition of
mortgage-related assets. We also expect that we may acquire mortgage-related
assets from Seneca's affiliates. In addition, we may, but have no current plans
to, invest as a co-participant with affiliates of Seneca in investments
originated or acquired by such affiliates. If under our guidelines such
investments are subject to review by our independent directors, it is
anticipated that they will rely primarily on information provided by Seneca.
Such conflicts may result in decisions and/or allocations of mortgage-related
assets by Seneca that are not in our best interests.
Many investments appropriate for us will also be appropriate for accounts
of other clients that Seneca advises. Pursuant to the terms of the management
agreement, Seneca will allocate investment and disposition opportunities in
accordance with policies and procedures Seneca considers fair and equitable,
including, without limitation, such considerations as investment objectives,
restrictions and time horizon, availability of cash and the amount of existing
holdings. However, situations may arise in which the investment activities of
Seneca or the other accounts may disadvantage us, such as the inability of the
market to fully absorb orders for the purchase or sale of particular securities
placed by Seneca for us and its other accounts at prices and in quantities which
would be obtained if the orders were being placed only for us. Seneca may
aggregate orders with orders for its other accounts. Such aggregation of orders
might not always be to our benefit with regard to the price or quantity
executed.
For so long as Seneca is our exclusive manager pursuant to the management
agreement, absent approval by a majority of our independent directors, Seneca
has agreed not to sponsor any other mortgage REIT that invests primarily in
high-quality, residential mortgage-backed securities.
69
THE MANAGER
GENERAL
Established in 1989, Seneca Capital Management LLC is a registered
investment adviser under the Investment Advisers Act. Seneca currently engages
in investment management as its sole business and manages fixed-income and
equity assets for pension and profit sharing plans, financial institutions such
as banking and insurance companies and mutual funds for retail and institutional
investors. Seneca's address is 909 Montgomery Street, Suite 500, San Francisco,
California 94133.
A majority of the outstanding equity interests of Seneca are owned by
Phoenix Investment Partners, Ltd. Phoenix Investment is a wholly-owned
subsidiary of The Phoenix Companies, Inc. (NYSE:PNX). Our board of directors
consists of seven members, five of whom are unaffiliated with Seneca or Phoenix.
Neither this prospectus nor this offering are endorsed or guaranteed in any way
by Seneca or Phoenix.
THE MANAGEMENT AGREEMENT
SERVICES AND DUTIES OF THE MANAGER
We entered into a management agreement with Seneca on June 11, 2003, the
initial closing date of our private offering of common stock. Pursuant to the
management agreement, Seneca, as our sole manager, generally implements our
business strategy, is responsible for our day-to-day operations and performs
services and activities relating to our assets and operations in accordance with
the terms of the management agreement. Ms. Seneca and Messrs. Gutierrez, Chow
and Grande currently perform the duties of Seneca pursuant to the management
agreement on behalf of Seneca. However, Seneca may elect to have others
undertake some or all of those duties at any time and in its sole discretion.
Seneca is primarily involved in three activities:
- Asset Management -- Seneca advises us with respect to, and arranges for
and manages the acquisition, financing, management and disposition of,
our investments.
- Liability Management -- Seneca evaluates the credit risk and prepayment
risk of our investments and arranges appropriate borrowing and hedging
strategies.
- Capital Management -- Seneca coordinates our capital raising activities.
Subject at all times to the direction and oversight of our board of
directors, Seneca performs the following services and other activities in
accordance with the terms of the management agreement and, to the extent
directed by our board of directors, performs similar services and other
activities for any subsidiary of our company:
- serving as our consultant with respect to the formulation of investment
criteria and the preparation of policy guidelines by our board of
directors;
- assisting us in developing criteria for mortgage-related purchase
commitments that are consistent with our long-term investment objectives
and making available to us Seneca's knowledge and experience with respect
to mortgage-related assets;
- representing us in connection with the purchase, sale and commitment to
purchase or sell mortgage-related assets that meet in all material
respects our investment criteria, and managing our portfolio of
mortgage-related assets;
- advising us and negotiating our agreements with third-party lenders for
borrowings by us;
- making available to us statistical and economic research and analysis
regarding our activities and the services performed for us by Seneca;
- monitoring and providing to our board of directors from time to time
price information and other data obtained from certain
nationally-recognized dealers that maintain markets in mortgage-related
70
assets identified by our board of directors from time to time, and
providing data and advice to our board of directors in connection with
the identification of such dealers;
- investing or reinvesting any of our money in accordance with our policies
and procedures;
- providing the executive and administrative personnel, office space and
services required in rendering services to us, in accordance with and
subject to the terms of the management agreement;
- administering our day-to-day operations and performing and supervising
the performance of such other administrative functions necessary to our
management as may be agreed upon by Seneca and our board of directors,
including the collection of our revenues and the payment of our debts and
obligations from our accounts, and the maintenance of appropriate
computer systems to perform such administrative functions;
- advising our board of directors in connection with policy decisions;
- evaluating and recommending hedging strategies to our board of directors
and, upon approval by our board of directors, engaging in hedging
activities on our behalf consistent with our status as a REIT;
- supervising our compliance with the REIT provisions of the Internal
Revenue Code and our maintenance of our status as a REIT;
- qualifying and causing us to qualify to do business in all applicable
jurisdictions and obtaining and maintaining all appropriate licenses;
- assisting us to retain qualified accountants and tax experts to assist in
developing and monitoring appropriate accounting procedures and testing
systems and to conduct quarterly compliance reviews as our board of
directors may deem necessary or advisable;
- assisting us in our compliance with all federal (including the
Sarbanes-Oxley Act of 2002), state and local regulatory requirements
applicable to us in respect of our business activities, including
preparing or causing to be prepared all financial statements required
under applicable regulations and contractual undertakings and all
reports, documents and filings, if any, required under the Securities
Exchange Act of 1934, as amended, or the Exchange Act, or other federal
or state laws;
- assisting us in our compliance with federal, state and local tax filings
and reports and generally enabling us to maintain our status as a REIT,
including soliciting stockholders, as defined below, for required
information to the extent provided in the REIT provisions of the Internal
Revenue Code;
- assisting us in our maintenance of an exemption from the Investment
Company Act and monitoring our compliance with the requirements for
maintaining an exemption from the Investment Company Act;
- coordinating and managing the operations of any joint venture or
co-investment interests held by us and conducting all matters with the
joint venture or co-investment collaborators;
- advising us as to our capital structure and capital raising activities;
- handling and resolving all claims, disputes or controversies (including
all litigation, arbitration, settlement or other proceedings or
negotiations) in which we may be involved or to which we may be subject
arising out of our day-to-day operations, subject to the approval of our
board of directors;
- engaging and supervising, on behalf of us and at our expense, the
following, without limitation: independent contractors to provide
investment banking services, leasing services, mortgage brokerage
services, securities brokerage services, other financial services, and
such other services as may be deemed by Seneca or our board of directors
to be necessary or advisable from time to time; and
71
- so long as Seneca does not incur additional costs or expenses, performing
such other services as may be required from time to time for management
and other activities relating to our assets as our board of directors
shall reasonably request or Seneca shall deem appropriate under the
particular circumstances.
Seneca, in its sole discretion, may elect to cause these services to be
provided by third parties, including affiliates of Seneca, in certain cases at
our expense, provided that the payment to any affiliate of Seneca by us is
subject to the approval of our independent directors (or in accordance with a
policy adopted by those board members).
Seneca is required to manage our business affairs in general conformity
with the policies approved by our board of directors and consistent with our
manager's duties under the management agreement. Seneca is required to prepare
regular reports for our board of directors that will review our acquisitions of
assets, portfolio composition and characteristics, credit quality, performance
and compliance with our investment policies and policies that will enable us to
maintain our qualification as a REIT and prevent us from being deemed an
investment company.
From time to time, our board of directors will assess whether we should be
internally managed. This assessment will be based on a number of factors deemed
relevant by our board of directors, including our ability to attract and retain
full-time employees and the costs and expenses related to becoming internally
managed.
TERM
The management agreement was entered into on June 11, 2003 and remains in
effect until terminated.
Terminations by us for Cause. Our directors who are not affiliated with
Seneca have the right to terminate the management agreement for cause, by a
two-thirds vote, at any time. "Cause" means a reasonable, good faith
determination that Seneca was grossly negligent, acted with reckless disregard
or engaged in willful misconduct or active fraud while discharging its material
duties under the management agreement. The unaffiliated directors' determination
that cause exists must be based on findings of fact disclosed to Seneca. If
their good faith determination that cause exists is based primarily on a finding
of criminal activity or active fraud, we may terminate the management agreement
immediately. If their good faith determination that cause exists is based
primarily on findings other than criminal activity or fraud, we must give Seneca
written notice disclosing the findings of the unaffiliated directors and allow
Seneca a reasonable opportunity to cure the problem. If after 60 days the
unaffiliated directors determine that cause continues to exist, then the
unaffiliated directors may terminate the management agreement immediately by a
two-thirds vote. We will not have an obligation to pay Seneca a termination fee
if we terminate the management agreement for cause; however, we will be
obligated to pay Seneca all unpaid costs and expenses reimbursable under the
management agreement.
Terminations without Cause. From and after June 11, 2004, Seneca has the
right to terminate the management agreement for any reason by giving at least 60
days' prior written notice to our board of directors. We will not be obligated
to pay Seneca any termination fee in that case (unless Seneca's termination is
within 90 days of a change of control, as described below), however, we will be
obligated to pay Seneca all unpaid fees and expenses reimbursable under the
management agreement.
Similarly, from and after June 11, 2004, our directors who are not
affiliated with Seneca have the right to terminate the management agreement
without cause, by a two-thirds vote, by giving at least 60 days' prior written
notice to Seneca. If we terminate the management agreement without cause, we
will be required to pay Seneca all unpaid fees and expenses reimbursable under
the management agreement plus a termination fee. The termination fee differs,
depending upon the circumstances of the termination as follows:
- If we terminate the management agreement without cause in connection with
a decision to manage our portfolio internally, rather than by an external
manager, the amount of the termination fee shall
72
be equal to the amount of the highest annual base fee and the highest
annual incentive compensation, for a particular year, earned by Seneca
during any of the three years (or on an annualized basis if a lesser
period) preceding the effective date of the termination, plus accelerated
vesting on the equity component of all incentive compensation.
- If we terminate the management agreement without cause for any other
reason, the amount of the termination fee shall be equal to two times the
amount of the highest annual base fee and the highest annual incentive
compensation, for a particular year, earned by Seneca during any of the
three years (or on an annualized basis if a lesser period) preceding the
effective date of the termination, plus all deferred payments, including
accelerated vesting on the equity component of all incentive
compensation.
Terminations by Seneca upon a Change of Control. Subject to exceptions
specified in the management agreement, Seneca has the right to deliver a notice
of termination of the management agreement within 90 days of a change of
control. A change of control is deemed to occur on:
- the date of (a) any sale, lease, assignment, transfer or other conveyance
of all or substantially all of the Company's assets; (b) any
consolidation or merger involving our company in which all of the
stockholders of our company immediately prior to the transaction,
considered collectively, do not immediately following the transaction own
shares of the surviving entity constituting at least a majority of the
voting power of the surviving entity; (c) any capital reclassification or
other recapitalization of our company in which any person or group that
owned thirty percent or more of our voting power falls below that
threshold or in which any person or group that owned less than thirty
percent of our voting power rises above that ceiling; or (d) any
liquidation, dissolution or winding up of our company; or
- the first date on which fewer than two of our directors are persons whose
nomination to the board was supported by Seneca. Currently, the board
seats of Ms. Seneca and Mr. Gutierrez are supported by Seneca. Seneca has
informed us that it will generally support the nomination of persons
employed by, or affiliated with, Seneca. We intend to disclose in our
proxy statements regarding the election of directors whether a
candidate's nomination is supported by Seneca.
Any notice of termination by Seneca following a change of control will be
effective no less than 60 days after its date of delivery. If Seneca terminates
the management agreement following a change of control, we will be required to
pay Seneca all unpaid fees and expenses reimbursable under the management
agreement, and the same termination fee as would be payable if we terminated the
management agreement without cause (namely, two times the highest annual base
fee and the highest annual incentive compensation, for a particular year, earned
by Seneca during any one of the three years preceding termination, plus all
deferred payments, including accelerated vesting on the equity component of all
incentive compensation).
73
MANAGEMENT COMPENSATION AND EXPENSES
The following table presents a summary of certain compensation, fees and
other benefits (including reimbursement of certain out-of-pocket expenses paid
by Seneca to third parties pursuant to the management agreement) that Seneca may
earn or receive from us pursuant to the terms of the management agreement and
the cost-sharing agreement.
TYPE DESCRIPTION AND METHOD OF COMPUTATION AMOUNT
---- ------------------------------------- ------
Base management fee 1% per annum of the first $300 million of our $4.1 million(1)
average net worth during each fiscal year,
plus 0.8% per annum of our average net worth
in excess of $300 million during such fiscal
year, as described in more detail below.
Incentive compensation A specified percentage of our REIT taxable Determinable based upon
net income, (before deducting incentive REIT taxable net income
compensation, net operating losses and (before deducting
certain other items), in excess of a incentive compensation,
threshold amount of net income, as described net operating losses
in more detail below. and certain other
items.(2)
Out-of-pocket expense Reimbursement of actual out-of-pocket Determinable based upon
reimbursements expenses incurred in connection with our actual out-of-pocket
administration on an ongoing basis. expenses.(3)
Reimbursement of Reimbursement of actual costs attributable to Determinable based upon
overhead expenses our use of services rendered by Seneca actual overhead
pursuant to the cost-sharing agreement. Our expenses attributed to
portion of such costs is allocated to us as us.(4)
determined by Seneca, subject to reasonable
approval of a majority of our independent
directors.
Termination fee Fee payable only upon termination by us Determinable based upon
without cause or by Seneca upon change of amount of management
control. Actual amount of fee depends upon fees actually paid to
the circumstances of the termination.(5) Seneca during the then
three most recent years
at time of termination.
---------------
(1) Amount represents estimated maximum base management fee for 2004. This is
based on an average net worth for purposes of calculating base management
fee of $434.5 million for fiscal year 2004, and assuming (a) net worth for
purposes of calculating base management fee of $309.5 million on December
31, 2003 and full leverage of 12 times our equity as of such date, (b) net
proceeds in this offering of $157.5 million on March 31, 2004 and immediate
leverage of 12 times our equity as of such date, and (c) quarterly
distributions to our stockholders in an amount equal to our earnings during
each fiscal quarter in 2004 on the last day of each such quarter. Actual
base management fees payable to Seneca and distributions payable to our
stockholders for fiscal year 2004 may be greater or less than these
estimated amounts. In addition, because the amount of leverage (defined as
our total debt divided by stockholder's equity) on our equity which we
generally seek to obtain is between eight and 12 times, our actual leverage
may be greater or less than the 12 times leverage assumed in the above
calculations, which may cause the base compensation under the management
agreement to be greater or less than the estimated amounts. Our borrowings
as of December 31, 2003 were 6.1 times the amount of our equity. We paid
base management fees of $901,351 in 2003.
(2) Due to the uncertainty surrounding 10-year U.S. Treasury yields and net
interest margin, it is not possible to calculate a reasonable estimate of
the maximum incentive compensation for 2004. During 2003, Seneca earned
incentive compensation of $1,219,446. However, during the quarter ended
September 30, 2003, Seneca earned incentive compensation of $613,247 and
voluntarily waived that compensation on a one-time basis due to the net loss
we suffered during that same period. The waived incentive fee has been
accounted for as a capital contribution as of September 30, 2003 and was
expensed in the quarter ended September 30, 2003.
(3) Aggregate out-of-pocket expenses in the amount of $1.3 million were paid to
Seneca and/or its affiliates under the management agreement from inception
through December 31, 2003 and $16 thousand was payable to Seneca at December
31, 2003.
(4) Expenses of $6 thousand were paid to Seneca under the cost-sharing agreement
from inception through December 31, 2003.
(5) If we terminate the management agreement without cause in connection with a
decision to manage our portfolio internally, we will be obligated to pay to
Seneca a fee equal to the highest amount of management fees incurred in a
particular year during the then three most recent years. Alternatively, if
we terminate the management agreement without cause for any other reason, we
will be obligated to pay Seneca an amount equal to two times the highest
amount of management fees incurred in a particular year during the then
three most recent years.
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Base Management Fee. The base management fee is equal to 1% of the first
$300 million of our average net worth during each fiscal year, plus 0.8% of our
average net worth in excess of $300 million during such fiscal year. Our average
net worth will be calculated as the difference between the aggregate amortized
book value of the consolidated assets of us and our subsidiaries, before
reserves for depreciation or bad debt or other similar non-cash items, less the
aggregate book value of our debt, computed by taking the average of such net
values at the end of each month during the applicable period. The base
management fee will be paid quarterly.
The base management fee is intended to compensate Seneca for its costs in
providing management services to us. Seneca is expected to use the proceeds from
its base management fee and incentive compensation in part to pay compensation
to its officers and employees who have no right to receive cash compensation
directly from us, even though some of them also are our officers.
Incentive Compensation. Except as otherwise approved by our board of
directors, the management agreement provides that one-half of Seneca's incentive
compensation payable quarterly shall be paid in cash and one-half shall be paid
in shares of our common stock. The common stock portion of the incentive
compensation arising under the management agreement will be subject to a
three-year vesting schedule with one third of such stock vesting on each
anniversary of the issuance of such stock. The vesting schedule of the common
stock may be subject to acceleration in the event of, among other things, a
termination by us without cause or in the event of a change of control of
Luminent. The number of shares to be received by Seneca will be based on the
fair market value of these shares, less a discount determined by our board of
directors at the time of issuance to account for transfer restrictions during
the vesting period. We have agreed to register the resale of these shares of our
common stock. We have also granted Seneca the right to include these shares in
any registration statements we might file in connection with any future public
offerings, subject only to the right of the underwriters of those offerings to
reduce the total number of secondary shares included in those offerings (with
such reductions to be proportionately allocated among selling stockholders
participating in those offerings). Seneca will be entitled to receive incentive
compensation for each fiscal quarter (or lesser portion thereof) in an amount
equal to the tiered percentage of the difference between our net income (which
is our taxable income (including net capital gains, if any, but excluding net
capital losses, if any) before deducting incentive compensation, net operating
losses arising from prior periods, and items permitted by the Internal Revenue
Code when calculating taxable income for a REIT) for such fiscal quarter (or
lesser portion thereof), and the threshold return for such fiscal quarter (or
lesser portion thereof). The "tiered percentage" for this calculation is the
weighted-average of the following percentages based on our average net invested
assets for the period: (1) 20% for the first $400 million of average net
invested assets; and (2) 10% of our average net invested assets in excess of
$400 million. "Threshold return" means the amount of net income for the period
that would produce an annualized return on our average net invested assets equal
to the 10-year U.S. Treasury rate for such fiscal quarter plus 2.0%. The
"average net invested assets" shall mean for any period the arithmetic average
of the aggregate of the net proceeds from offerings of our equity securities
(after deducting underwriting discounts and commissions and other costs and
expenses related thereto), computed by taking the average of such values at the
end of each week during the applicable period. Incentive compensation shall be
paid quarterly. However, if at the end of a particular fiscal year or upon any
termination of the management agreement the aggregate of the incentive
compensation received by Seneca during that fiscal year (or lesser portion
thereof) exceeds the tiered percentage of the difference of our net income for
that fiscal year (or lesser portion thereof) less the threshold return for such
year (or lesser portion thereof), then Seneca will pay us such amount at the
time of such reconciliation at the end of the applicable fiscal year. Any such
payments by Seneca will not exceed the amount of the incentive compensation
previously paid to Seneca under the management agreement for that fiscal year
(or lesser portion thereof) and will be made only to the extent of the
reconciliation amount for that fiscal year (or lesser portion thereof), half of
which shall be in cash and the balance of which shall be in stock. If Seneca is
required to return stock as aforesaid, then Seneca will first return the shares
of stock that it received last as incentive compensation at the actual price of
such shares as of their original issuance in each case.
75
Expense reimbursements. Seneca may engage its affiliates and other third
parties to conduct due diligence with respect to potential investments and to
provide certain other services. Under the management agreement, Seneca may be
entitled to reimbursement for the fees and expenses of those third parties, some
of which may be affiliates of Seneca. Accordingly, a portion of the
out-of-pocket expenses may be paid to affiliates of Seneca in such capacities.
We rely on the personnel (other than our chief financial officer) and
resources of Seneca to conduct our operations. We reimburse Seneca for Seneca's
costs and expenses for the items described below and for the fees and expenses
of certain third parties (which may include affiliates of Seneca) engaged to
perform professional services (including legal and accounting) for us, and to
perform due diligence tasks on assets purchased or considered for purchase by us
and to perform certain other activities. Further, we reimburse Seneca for any
expenses incurred in contracting with third parties for the master or special
servicing of assets we acquire. Accordingly, a portion of the out-of-pocket
expenses may be paid to Seneca's affiliates in such capacities. The contracting
for such engagements is conducted on commercially reasonable terms. We have also
entered into a cost-sharing agreement with Seneca regarding certain overhead
items such as space, utilities and other administrative services. Such
arrangements may also be made using an income-sharing arrangement such as a
joint venture. Expense reimbursement may be made as frequently as monthly.
Subject to the limitations set forth below, we pay all of our operating
expenses except those specifically required to be borne by Seneca under the
management agreement. The operating expenses required to be borne by Seneca
include:
- most costs and expenses of its officers and employees;
- the costs of any salaries of any of our officers or directors who are
affiliated with Seneca;
- all internal and overhead expenses of Seneca, except for our pro-rata
portion of overhead to the extent that our employees who are not also
employed by Seneca use Seneca's facilities, and
- fees and expenses of third parties that are engaged by Seneca to perform
services for us but for which Seneca is specifically not entitled to
reimbursement under the management agreement, except that our board of
directors may approve reimbursement to Seneca of our pro rata portion of
the salaries, bonuses, health insurance, retirement benefits and similar
employment costs for the time spent on our operations and administration
other than for the provision of investment advisory services.
The expenses that we pay include (but are not necessarily limited to):
- issuance and transaction costs associated with the acquisition,
disposition and financing of investments;
- legal, independent accounting and auditing fees and expenses;
- the compensation and expenses of our independent directors;
- the costs of printing and mailing proxies and reports to stockholders;
- costs incurred by employees of Seneca for travel on behalf of us;
- costs associated with any computer software or hardware that is used
solely for us;
- costs to obtain liability insurance to indemnify our directors and
officers, Seneca and its employees and directors;
- the compensation and expenses of our custodian and transfer agent;
- all expenses incurred in connection with due diligence;
- the accumulation of mortgage-related assets;
- the raising of capital and incurrence of debt;
76
- the acquisition of assets;
- interest expenses;
- taxes and license fees;
- non-cash costs;
- litigation;
- the base and incentive management fee; and
- extraordinary or non-recurring expenses.
Services for which we bear the expenses may be provided to us by affiliates
of Seneca if Seneca believes such services are of comparable or superior quality
to those provided by third parties and can be provided at comparable cost.
Seneca is required under the management agreement to provide an annual report to
our board of directors with respect to the engagement of third parties and fees
and expenses paid to such third parties, and our board of directors will
periodically review such engagements and our expense levels, the division of
expenses between Seneca and us and reimbursements of expenses advanced by
Seneca.
Seneca is permitted to incur expenses on our behalf that are consistent
with a budget that may, in the future, be approved by our board of directors, as
amended from time to time, are consistent with the terms of the management
agreement or are at the direction of our board. Nevertheless, Seneca must obtain
the approval of our board for any expense item exceeding $100,000 in the
aggregate, except as otherwise provided for in our budget. Our board of
directors may modify this threshold from time to time in its discretion.
STOCK OPTION GRANTS
We are not obligated to grant any options to Seneca or any of its
employees. However, under our 2003 outside advisors plan we are authorized, from
time to time in the discretion of the compensation committee of our board of
directors, to grant options to purchase shares of our common stock to Seneca
and/or its directors, officers, and key employees.
CONFLICTS OF INTEREST
We are subject to conflicts of interest involving Seneca and its affiliates
because, among other reasons:
- the incentive compensation, which is based on our income, may create an
incentive for Seneca to recommend investments with greater income
potential, which may be relatively more risky, than would be the case if
its compensation from us did not include an incentive-based component;
- Seneca and its affiliates are permitted to purchase mortgage-related
assets for their own account and to advise accounts of other clients, and
many investment opportunities appropriate for us also will be appropriate
for these accounts; and
- two of our directors and all but one of our executive officers are
managers or employees of, or otherwise affiliated with, Seneca.
For a more detailed discussion, see "Conflicts of Interest; Certain
Relationships and Related Transactions."
The management agreement does not limit or restrict the right of Seneca or
any of its affiliates from engaging in any business or rendering services of any
kind to any other person, including the purchase of, or rendering advice to
others purchasing, mortgage-related assets that meet our policies and criteria.
However, Seneca has agreed that for as long as Seneca is our exclusive manager
pursuant to the management agreement, it will not sponsor any other mortgage
REIT that invests primarily in high-
77
quality, residential mortgage-backed securities, without first obtaining the
approval of a majority of our independent directors.
LIMITS OF RESPONSIBILITY
Pursuant to the management agreement, Seneca has not assumed any
responsibility other than to undertake the services called for thereunder and is
not responsible for any decision by our board of directors to follow or not to
follow its advice or recommendations. Seneca, its managers and employees will
not be liable to us, any issuer of mortgage-backed securities, any of our
subsidiaries, the independent directors, our stockholders or any subsidiary's
stockholders for acts performed in accordance with and pursuant to the
management agreement, unless our independent directors have made a reasonable,
good faith determination based on findings of fact which are disclosed to Seneca
that Seneca was grossly negligent, acted with reckless disregard, or engaged in
willful misconduct or active fraud while discharging its material duties under
the management agreement. We cannot assure you that we would be able to recover
any damages for claims we may have against Seneca. Although certain managers and
employees of Seneca are also our officers and directors and, therefore, have
fiduciary duties to us and our stockholders in that capacity, Seneca and the
managers and employees of Seneca, in their capacities as such, have no fiduciary
duties to us.
We have agreed to indemnify Seneca and its directors, officers, employees
and affiliates with respect to all expenses, losses, damages, liabilities,
demands, charges and claims arising from any acts or omissions of Seneca or its
employees made in the performance of Seneca's duties under the management
agreement, but excluding acts or omissions for which our independent directors
have made a reasonable, good faith determination based on findings of fact which
are disclosed to Seneca that Seneca was grossly negligent, acted with reckless
disregard, or engaged in willful misconduct or active fraud while discharging
its material duties under the management agreement. The management agreement
does not limit or restrict the right of Seneca or any of its officers,
directors, employees or affiliates from engaging in any business or rendering
services of any kind to any other person, including the purchase of, or
rendering advice to others purchasing, mortgage- related assets that meet our
policies and criteria.
THE COST-SHARING AGREEMENT
We have entered into a cost-sharing agreement with Seneca regarding
overhead items such as space, utilities and other administrative services.
Pursuant to the cost-sharing agreement, Seneca has agreed to provide, and we
have agreed to reimburse Seneca for the costs of, the use of up to 1,500 square
feet of space at Seneca's principal offices and utilities, furniture,
furnishings and equipment (including computer equipment), telephone, telegraph
and fax services, mail services, and other administrative services utilized by
our officers and employees that are not affiliated with Seneca. We are obligated
to pay the actual costs attributable to our use of the services rendered by
Seneca under the cost-sharing agreement, which shall be determined by Seneca and
which determination is subject to the reasonable approval of a majority of our
independent directors. Our independent directors may approve a set of guidelines
for the determination and reimbursement of costs to Seneca under the
cost-sharing agreement in order to permit such determination and reimbursement
to occur without prior approval by our independent directors in each instance.
The cost-sharing agreement will terminate upon the termination of the management
agreement in accordance with its terms. Expenses of $6 thousand have been paid
to Seneca under the cost-sharing agreement from inception through December 31,
2003.
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MANAGEMENT OF THE COMPANY
OUR DIRECTORS AND EXECUTIVE OFFICERS
The following table provides information regarding our directors and
executive officers:
BOARD BOARD TERM
NAME AGE POSITION CLASS EXPIRES
---- --- -------- ----- ----------
INSIDE DIRECTORS
Gail P. Seneca, Ph.D. ....... 51 Chairman of the Board and Chief II 2005
Executive Officer
Albert J. Gutierrez, CFA..... 42 President and Director I 2004
INDEPENDENT DIRECTORS
Bruce A. Miller, CPA......... 61 Lead Independent Director(1)(2) III 2006
Robert B. Goldstein.......... 63 Independent Director(1)(2)(3) II 2005
John McMahan................. 66 Independent Director(1)(2)(3) I 2004
Donald H. Putnam............. 52 Independent Director(2)(3) III 2006
Joseph E. Whitters, CPA...... 45 Independent Director(1) I 2004
EXECUTIVE OFFICERS WHO ARE NOT
DIRECTORS
Christopher J. Zyda.......... 41 Senior Vice President and Chief
Financial Officer
Andrew S. Chow, CFA.......... 40 Senior Vice President
Troy A. Grande, CFA.......... 40 Senior Vice President
---------------
(1) Member of Audit Committee.
(2) Member of Compensation Committee.
(3) Member of Governance and Nominating Committee.
EMPLOYEE AND NON-EMPLOYEE OFFICERS
We employ a full-time chief financial officer, Christopher J. Zyda, whose
primary responsibilities include monitoring Seneca's performance under the
management agreement.
We do not employ any of our officers other than Mr. Zyda. Our other
executive officers -- Ms. Seneca, Mr. Gutierrez, Mr. Chow and Mr. Grande -- are
employees and/or officers of Seneca and are compensated by Seneca. In their
capacity as officers of our company, these non-employee officers perform only
ministerial functions, such as executing contracts and filing reports with
regulatory agencies. In their capacity as officers and employees of Seneca, they
are expected to fulfill Seneca's duties to us under the management agreement.
(However, we have no control over which persons Seneca assigns to our account.)
In their capacity as officers and employees of Seneca, such persons do not have
fiduciary obligations to us or our stockholders.
BUSINESS EXPERIENCE OF OUR DIRECTORS AND EXECUTIVE OFFICERS
Set forth below is a brief account of the business experience and education
of our directors and executive officers.
GAIL P. SENECA, PH.D. Ms. Seneca is our chief executive officer and
chairman of our board of directors. Ms. Seneca is also the chief investment
officer and managing partner of Seneca Capital Management LLC. Prior to founding
Seneca Capital Management LLC in 1989, Ms. Seneca served as senior vice
president of the Asset Management Division of Wells Fargo Bank from 1987 to
1989, where she managed assets in excess of $10 billion. Before Wells Fargo, Ms.
Seneca was a chief investment
79
strategist and head of fixed income for Chase Lincoln First Bank from 1983 to
1987. She began her career in investments in the savings and loan industry. Ms.
Seneca attended New York University where she earned B.A., M.A. and Ph.D
degrees.
ALBERT J. GUTIERREZ, CFA. Mr. Gutierrez is our president and a member of
our board of directors. Mr. Gutierrez is also the fixed-income chief investment
officer for Seneca, which he joined as a principal in 2002. Prior to joining
Seneca, Mr. Gutierrez was employed at American General Investment Management as
executive vice president from 2000 to 2001. At American General, Mr. Gutierrez
was head of portfolio management, trading and investment systems where he was
responsible for approximately $75 billion in client assets. From 1988 to 2000,
Mr. Gutierrez was employed by Conseco Capital Management as a senior vice
president in charge of fixed-income research and trading as well as insurance
asset portfolio management. Mr. Gutierrez' broad portfolio management experience
includes total-rate-of-return mandates in all fixed-income sectors,
collateralized debt obligations, and specialized and structured mandates. Prior
to joining Conseco Capital Management, Mr. Gutierrez held successive roles on
Wall Street in credit research, systems design and trading. Mr. Gutierrez holds
a B.S. degree in Economics from the Wharton School, University of Pennsylvania,
and is a CFA charter holder.
BRUCE A. MILLER, CPA. Mr. Miller is our lead independent director. Mr.
Miller is the retired managing partner of the E&Y Kenneth Leventhal Real Estate
Group, San Francisco, where he served from 1980 to 1999. Mr. Miller is a
certified public accountant and affiliated with the American Institute of
Certified Public Accountants. Mr. Miller is the chairman of the board of Limbic
Systems, Inc., president of the board of The San Francisco Food Bank and is a
director of AMB Institutional Alliance REIT I, Inc., Great Circle Water
(Technologies), Inc., California Center for Land Recycling, and Whitney Cressman
Limited. Mr. Miller is on the Advisory Board of Hunting Gate Capital, LLC. Mr.
Miller earned a B.A. degree from Drexel University and an M.B.A. degree from New
York University.
ROBERT B. GOLDSTEIN. Mr. Goldstein is an independent director on our
board. Mr. Goldstein is chairman of the board of directors of Bay View Capital
Corporation. Mr. Goldstein has served as a director of Bay View Capital
Corporation since 2001, and formerly served as its president and chief executive
officer. Previously, Mr. Goldstein served as president of the Jefferson Division
of Hudson United Bank in Philadelphia since 2000, when Hudson United acquired
Jeff Banks Inc., and was president of Jeff Banks Inc. from 1998 to 2000. Mr.
Goldstein was chairman and chief executive officer of Regent Bancshares Corp.
and Regent National Bank, Philadelphia, Pennsylvania, from 1997 to 1998, and
from 1993 to 1996 he served as president and chief executive officer of
Lafayette American Bank in Connecticut. Mr. Goldstein holds a B.B.A. degree from
Texas Christian University, from which he graduated magna cum laude, and also
served for seven years on the faculty of Southern Methodist University's
Graduate School of Banking.
JOHN MCMAHAN. Mr. McMahan is an independent director on our board. Mr.
McMahan is also chairman of the board of directors of BRE Properties, Inc. Mr.
McMahan has served as a director of BRE Properties since 1995. He has been
executive director for The Center for Real Estate Enterprise Management since
2000, and managing principal of The McMahan Group, real estate management
consultants, since 1996. Previously, Mr. McMahan founded and served as chief
executive officer of McMahan Real Estate Advisors from 1980 through 1990. In
1990, Mr. McMahan's firm merged with a subsidiary of Mellon Bank to form
Mellon/McMahan Real Estate Advisors Inc., a real estate pension fund advisory
firm of which Mr. McMahan was the chief executive officer from 1990 until 1994.
Subsequent to the merger, Mellon/McMahan Real Estate Advisors Inc. became the
16th largest real estate pension fund advisor in the U.S. with approximately
$2.2 billion under management. Mr. McMahan taught real estate at the Stanford
Graduate School of Business for 17 years and at the Haas School of Business,
University of California, Berkeley for five years. Mr. McMahan holds a B.A.
degree from the University of Southern California and an M.B.A. degree from
Harvard University.
DONALD H. PUTNAM. Mr. Putnam is an independent director on our board. Mr.
Putnam is the chief executive officer and a managing director of Putnam Lovell
NBF Securities Inc., an investment banking firm that advises the financial
services community, which he co-founded in 1987. From 1980 to 1986,
80
Mr. Putnam held various senior positions, at SEI Investments Inc., an investment
advisory firm to mutual funds with assets under management of over $15.0
billion. Prior to joining SEI, Mr. Putnam was a senior consultant at Catallatics
Corporation, a financial services company, where he devised new products and
strategies for banking clients. From 1973 to 1978, Mr. Putnam held various
positions in the trust and investment group of Bankers Trust Company. Mr.
Putnam's education includes undergraduate and graduate work at New York
University and undergraduate studies in mathematics and literature at Franklin
Pierce College.
JOSEPH E. WHITTERS, CPA. Mr. Whitters is an independent director on our
board. Mr. Whitters joined First Health Group Corp., a managed health care
company, as its controller in October 1986 and has served as its vice president,
finance from August 1987 to March 2004, its chief financial officer from March
1988 to March 2004 and its executive vice president of investor relations,
business development and acquisitions since March 2004. From 1984 through 1986,
he served as controller of United HealthCare Corp. (which subsequently changed
its name to UnitedHealth Group, Inc.), a diversified medical services company.
From 1983 to 1984, he served as manager of accounting and taxation for Overland
Express, a publicly-traded trucking company. From 1980 to 1983, he was a senior
manager for tax matters at Peat Marwick, a public accounting firm. Mr. Whitters
serves on the board of Omnicell, a public medication-dispensing technology
company and is the chairman of its audit committee. Mr. Whitters holds a B.A.
degree in accounting from Luther College in Decorah, Iowa.
CHRISTOPHER J. ZYDA. Mr. Zyda is our senior vice president and chief
financial officer. Prior to joining Luminent in August 2003, Mr. Zyda was
employed at eBay, Inc. from 2001 to 2003, where he served as vice president,
financial planning and analysis. Prior to eBay, Mr. Zyda was employed at
Amazon.com, Inc. from 1998 to 2001, where he held the positions of assistant
treasurer, then treasurer, and eventually vice president and chief financial
officer international. Prior to Amazon.com, Mr. Zyda was employed at The Walt
Disney Company from 1989 to 1998, where he held several positions within the
corporate treasury group, culminating as director, investments with
responsibility for over $4 billion of investment assets. Mr. Zyda earned a B.A.
degree in English Literature from the University of California Los Angeles, and
an M.B.A. degree from the Anderson School at UCLA.
ANDREW S. CHOW, CFA. Mr. Chow is a senior vice president of Luminent. Mr.
Chow is also a fixed-income portfolio manager for Seneca, which he joined in
2002. Before joining Seneca, Mr. Chow had been the portfolio manager since 2000
for a convertible securities mutual fund at ING Pilgrim which invested in both
investment-grade and high-yield securities. Prior to that time, Mr. Chow was
employed for nine years at Conseco Capital Management where he was the portfolio
manager for a highly ranked convertible securities mutual fund. Additionally, he
was responsible for trading and managing a multi-billion dollar matched options
book at Conseco. In previous roles at Conseco, Mr. Chow was a fixed-income
portfolio manager and a mortgage-backed securities trader. From 1988 to 1991,
Mr. Chow was employed at Washington Square Advisors where he was the manager of
quantitative research and also had responsibility for trading derivatives and
foreign exchange and mortgage-backed securities. Prior to that time, Mr. Chow
was a floor trader at the Minneapolis Grain Exchange. Mr. Chow holds a B.A.
degree in Economics from the University of California, Berkeley and an M.B.A.
degree from Carnegie Mellon. Mr. Chow is also a CFA charter holder.
TROY A. GRANDE, CFA. Mr. Grande is a senior vice president of Luminent.
Mr. Grande is also a fixed-income portfolio manager for Seneca, which he joined
in 2002 Before joining Seneca, Mr. Grande held staff and line positions at
Fremont General Corporation, where he served as assistant treasurer, director of
investments and chief financial officer. In these positions, he managed and
traded a multi-billion dollar fixed-income portfolio, evaluated and recommended
capital structure mix and was a member of the asset/liability committee for
their $2 billion thrift and loan subsidiary. Mr. Grande has extensive experience
in portfolio management of mortgage-backed securities, investment-grade
corporate bonds, government securities, bank loans and structured debt. Mr.
Grande also served as the chief financial officer at a financial services
division and at two private companies. Mr. Grande holds a B.A. degree in
Economics from Southern Methodist University and an M.B.A. degree from the
University of San Francisco. Mr. Grande is also a CFA charter holder.
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BOARD OF DIRECTORS
We currently have a seven-member board of directors. Under our bylaws, the
number of directors may be increased or decreased by the board, but may not be
fewer than the minimum number required by the MGCL (which is currently one) nor
more than 15. Any vacancy on our board of directors, whether resulting from the
death, resignation or removal of a director or from an increase in the size of
the board, may be filled only by a vote of our directors. Two of our directors
are affiliated with Seneca and five of our directors are independent, as defined
in our bylaws.
As defined by our bylaws, the term "independent director" refers to a
director who is neither:
- an officer or employee of our company; nor
- an officer, director, employee, partner, trustee or 10% owner of Seneca
or of any person controlling, controlled by or under common control with
Seneca.
Our bylaws require that a majority of the members of our board of directors
must at all times be independent directors, unless independent directors
comprise less than a majority as a result of a board vacancy. Our bylaws also
provide that all of the members of our audit committee, our compensation
committee and our governance and nominating committee must be independent
directors.
As required by rules of the NYSE, our board considered the independence of
each of our directors under the NYSE's standard of independence. Our board
affirmatively determined that Messrs. Miller, McMahan, Goldstein, Putnam and
Whitters have no material relationship with our company (either directly or as a
partner, stockholder or officer of an organization that has a relationship with
the company) and are thus independent under the NYSE's standard, as well as
under our bylaws' similar standard.
Our directors are divided into three classes serving staggered three-year
terms. As a result, every year one class, including approximately one-third of
our total number of directors, will stand for election (or re-election) by our
stockholders. Directors hold office until their successors are elected and
qualified or they resign or are removed. All officers serve at the discretion of
our board of directors.
Currently two classes of directors contain one affiliated director each
while the third class contains only independent directors.
- Mr. Gutierrez, Mr. McMahan and Mr. Whitters are Class I directors and
hold office for a term expiring at the annual meeting of stockholders in
2004;
- Ms. Seneca and Mr. Goldstein are Class II directors and hold office for a
term expiring at the annual meeting of stockholders in 2005; and
- Mr. Miller and Mr. Putnam are Class III directors. The term of office of
the Class III directors expires at the annual meeting of stockholders in
2006. However, since Mr. Putnam was elected by the board of directors to
fill a vacancy on the board created by an increase in the number of
directors, Mr. Putnam will hold office until the annual meeting of
stockholders in 2004 when he may be elected by the stockholders as a
Class III director to serve for the remaining term of the Class III
directors expiring at the annual meeting of stockholders in 2006.
COMPENSATION OF DIRECTORS
We pay each of our non-officer directors an annual fee of $30,000 for
service on our board (pro-rated for partial periods), plus a meeting fee of
$1,000 for each formally called board or committee meeting the non-officer
directors attend at which a quorum is present. We reimburse all of our directors
for the expenses they incur in connection with attending board and committee
meetings. We may, from time to time, in the discretion of the compensation
committee of our board of directors, grant options to purchase shares of our
common stock to our directors under our stock incentive plans described below.
We do not currently compensate our officer-directors for their service as
directors (or for their service as officers).
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INDEMNIFICATION
Our charter and bylaws provide for the indemnification of our directors and
officers to the fullest extent permitted by Maryland law. Our other employees
and agents may be indemnified to such extent as is authorized by our board of
directors or our bylaws. Maryland law generally permits indemnification of
directors, officers, employees and agents against certain judgments, penalties,
fines, settlements and reasonable expenses that any such person actually incurs
in connection with any proceeding to which such person may be made a party by
reason of serving in such positions, unless it is established that:
- an act or omission of the director, officer, employee or agent was
material to the matter giving rise to the proceeding and was committed in
bad faith or was the result of active and deliberate dishonesty;
- such person actually received an improper personal benefit in money,
property or services; or
- in the case of criminal proceedings, such person had reasonable cause to
believe that the act or omission was unlawful.
Our charter provides that the personal liability of any of our directors or
officers to us or our stockholders for money damages is limited to the fullest
extent allowed by the statutory or decisional law of the State of Maryland, as
amended or interpreted. As more fully described below under the caption "Certain
Provisions of Maryland Law and of our Charter and Bylaws," Maryland law
authorizes the limitation of liability of directors and officers to corporations
and their stockholders for money damages, except:
- to the extent that it is proved that the person actually received an
improper personal benefit; or
- to the extent that a judgment or other final adjudication adverse to the
person is entered in a proceeding based on a finding that the person's
action, or failure to act, was the result of active and deliberate
dishonesty and was material to the cause of action adjudicated.
We have also entered into indemnity agreements with each of our directors
and executive officers, as well as our manager and its officers, directors,
employees and some of its affiliates. The form of indemnity agreement is
included as an exhibit to the registration statement of which this prospectus is
a part. The indemnity agreements require, among other things, that we indemnify
such persons to the fullest extent permitted by law, and advance to such persons
all related expenses, subject to reimbursement if it is subsequently determined
that indemnification is not permitted. Under these agreements, we must also
indemnify and advance all expenses incurred by such persons seeking to enforce
their rights under the indemnification agreements, and may cover our directors
and executive officers under our directors' and officers' liability insurance.
Although the form of indemnity agreement offers substantially the same scope of
coverage afforded our directors and officers by law, it provides greater
assurance to our directors and officers and such other persons that
indemnification will be available because, as a contract, it may not be modified
unilaterally in the future by our board of directors or the stockholders to
eliminate the rights it provides.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers or persons controlling us pursuant to
the foregoing provisions, we have been informed that in the opinion of the SEC,
such indemnification is against public policy as expressed in the Securities Act
and is therefore unenforceable.
BOARD COMMITTEES AND MEETINGS
Our board has established an audit committee, a compensation committee and
a governance and nominating committee. Other committees may be established by
our board of directors from time to time.
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AUDIT COMMITTEE
Our audit committee is composed of four directors: Bruce A. Miller, CPA
(chairman), John McMahan, Robert B. Goldstein and Joseph E. Whitters, CPA. Our
board of directors has determined that all members of the audit committee
satisfy the new independence requirements of the NYSE. Our board has also
determined that:
- Messrs. Miller, Goldstein and Whitters qualify as "audit committee
financial experts," as defined by the SEC, and
- all members of the audit committee are "financially literate," within the
meaning of NYSE rules, and "independent," under the strict audit
committee independence standards of the SEC.
Our audit committee operates pursuant to a written charter adopted by the
board, which is included as an exhibit to the registration statement of which
this prospectus is a part. Among other things, the audit committee charter calls
upon the audit committee to:
- oversee the accounting and financial reporting processes and compliance
with legal and regulatory requirements on behalf of our board of
directors and report the results of its activities to the board;
- be directly and solely responsible for the appointment, retention,
compensation, oversight, evaluation and, when appropriate, the
termination and replacement of our independent auditors;
- review the annual engagement proposal and qualifications of our
independent auditors;
- prepare an annual report as required by applicable SEC disclosure rules;
- review the integrity, adequacy and effectiveness of our internal controls
and financial disclosure process;
- review and approve all related party transactions, including all
transactions with Seneca; and
- manage our relationship with Seneca under the management agreement.
COMPENSATION COMMITTEE
The members of our compensation committee are Robert B. Goldstein
(chairman), John McMahan, Bruce A. Miller, CPA and Donald H. Putnam. Our board
of directors has determined that all of the compensation committee members
qualify as:
- "independent directors" under the NYSE independence standards;
- "non-employee directors" under Exchange Act rule 16b-3; and
- "outside directors" under Internal Revenue Code section 162(m).
Our compensation committee has been delegated the authority by our board of
directors to administer all of our equity incentive plans, to determine the
chief executive officer's salary and bonus, if any, and to make salary and bonus
recommendations to our board regarding all other employees, including our chief
financial officer . Our compensation committee operates pursuant to a written
charter adopted by the board, which is included as an exhibit to the
registration statement of which this prospectus is a part. Among other things,
the compensation committee charter calls upon the compensation committee to:
- develop the overall compensation policies and the corporate goals and
objectives, if any, relevant to the chief executive officer's
compensation from our company;
- evaluate the chief executive officer's performance in light of those
goals and objectives, if any;
- be directly and solely responsible for establishing the chief executive
officer's compensation level, if any, based on this evaluation;
84
- make recommendations to the board regarding the compensation of officers
junior to the chief executive officer's, incentive compensation plans and
equity-based plans; and
- produce an annual report on executive compensation for inclusion in our
proxy statement.
Because we do not currently compensate any of our officers other than our
chief financial officer, and because our chief financial officer's base and
bonus compensation levels are largely established by his employment agreement
(as described below) which has been approved by the compensation committee, we
do not expect our compensation committee to be very active in the foreseeable
future.
GOVERNANCE AND NOMINATING COMMITTEE
Our governance and nominating committee has been formed to establish and
implement our corporate governance practices and to nominate individuals for
election to the board of directors. The members of our governance and nominating
committee are John McMahan (chairman), Robert B. Goldstein and Donald H. Putnam.
The committee is composed entirely of independent directors as required by NYSE
rules.
Our governance and nominating committee operates pursuant to a written
charter adopted by the board, which is included as an exhibit to the
registration statement of which this prospectus is a part. Among other things,
the committee charter calls upon the governance and nominating committee to:
- develop criteria for selecting new directors and to identify individuals
qualified to become board members and members of the various committees
of the board;
- select, or to recommend that the board select, the director nominees for
the each annual meeting of stockholders and the committee nominees; and
- develop and recommend to the board a set of corporate governance
principles applicable to the corporation.
CORPORATE GOVERNANCE
CORPORATE GOVERNANCE GUIDELINES
On the recommendation of the governance and nominating committee, our board
of directors adopted corporate governance guidelines, which are included as an
exhibit to the registration statement of which this prospectus is a part. The
guidelines address matters such as frequency of board meetings, director tenure,
director compensation, executive sessions of the independent directors,
communication with and among the directors and continuing education.
LEAD INDEPENDENT DIRECTOR
On the recommendation of the governance and nominating committee, our
independent directors meet in regularly scheduled executive sessions without
management. Our board of directors has established the position of lead
independent director and our independent directors have elected Mr. Miller to
serve in that position. In his role as lead independent director, Mr. Miller's
responsibilities will include:
- scheduling and chairing meetings of the independent directors, and
setting their agendas;
- facilitating communications between the independent directors and
management; and
- acting as a point of contact for persons who wish to communicate with the
independent directors.
Anyone wishing to communicate with the independent directors may write to
Mr. Miller through our corporate secretary, Peter T. Healy, Esq., O'Melveny &
Myers LLP, 275 Battery Street, Suite 2600, San Francisco, California,
94111-3344.
85
CODE OF BUSINESS CONDUCT AND ETHICS
Our board of directors has established a code of business conduct and
ethics, which is included as an exhibit to the registration statement of which
this prospectus is a part. Among other matters, the code of business conduct and
ethics is designed to deter wrongdoing and to promote:
- honest and ethical conduct, including the ethical handling of actual or
apparent conflicts of interest between personal and professional
relationships;
- full, fair, accurate, timely and understandable disclosure in our SEC
reports and other public communications;
- compliance with applicable governmental laws, rules and regulations;
- prompt internal reporting of violations of the code to appropriate
persons identified in the code; and
- accountability for adherence to the code.
Waivers to the code of business conduct and ethics may be granted only by
the governance and nominating committee of the board. In the event that the
committee grants any waivers of the elements listed above to any of our
officers, we expect to announce the waiver within five business days on the
corporate governance section of our corporate website at
www.luminentcapital.com. The information on that website is not a part of this
prospectus.
PUBLIC AVAILABILITY OF CORPORATE GOVERNANCE DOCUMENTS
Our key corporate governance documents, including our corporate governance
guidelines, our code of business conduct and the charters of our audit
committee, compensation committee and governance and nominating committee are:
- going to be posted on our website prior to May 26, 2004, the date of our
annual meeting;
- available in print to any stockholder who requests them from our
corporate secretary; and
- filed as exhibits to the registration statement of which this prospectus
is a part.
COMPENSATION OF EXECUTIVE OFFICERS
We have a full-time chief financial officer, Christopher J. Zyda, who is
employed by us. All of our other executive officers are employed by Seneca and
are compensated by Seneca. We do not separately compensate our officers, other
than Mr. Zyda, for their service as officers, nor do we reimburse Seneca for any
portion of our officers' compensation from Seneca, other than through the
general fees we pay to Seneca under the management agreement (which are
described under the caption "The Manager -- The Management
Agreement -- Compensation and Expenses"). In the future, our board or the
compensation committee may decide to pay annual compensation or bonuses and/or
long-term compensation awards to one or more of our non-employee officers for
their services as officers. We may from time to time, in the discretion of the
compensation committee of our board of directors, grant options to purchase
shares of our common stock to one or more of our other officers pursuant to our
stock incentive plans.
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The following table summarizes the compensation we have awarded or paid to
our chief executive officer and to our other four executive officers since our
inception. As mentioned above, we currently do not separately compensate our
executive officers other than Mr. Zyda. We refer to the persons identified in
the following table as our named executive officers.
SUMMARY COMPENSATION TABLE
LONG-TERM COMPENSATION(2)
-------------------------------
ANNUAL COMPENSATION DIVIDEND
----------------------------- STOCK OPTION EQUIVALENT ALL OTHER
NAME AND POSITION YEAR SALARY BONUS(1) OTHER AWARDS AWARDS RIGHTS COMPENSATION
----------------- ---- --------- --------- ----- ------- -------- ---------- ------------
Gail P. Seneca, Chairman
of the Board and Chief
Executive Officer..... 2003 -- -- -- -- -- -- --
Albert J. Gutierrez,
President............. 2003 -- -- -- -- -- -- --
Christopher J. Zyda,
Senior Vice President
and Chief Financial
Officer............... 2003 $82,192(2) $15,155(3) -- 1,283(3) 50,000(4) -- --
Andrew S. Chow, Senior
Vice President........ 2003 -- -- -- -- -- -- --
Troy A. Grande, Senior
Vice President........ 2003 -- -- -- -- -- -- --
---------------
(1) Amounts presented as bonus awards, stock awards, stock option awards and
dividend equivalent right, or DER, awards for 2003 are amounts actually
awarded by our compensation committee. Our compensation committee has the
right to issue additional stock awards, stock options and DERs to our
officers at any time.
(2) Mr. Zyda's employment by us commenced on August 4, 2003. In 2003, we paid
Mr. Zyda the salary shown above. Mr. Zyda's salary rate resets on the first
day of each calendar month based upon our net worth on the final day of the
preceding month as described under "-- Employment Agreement with Christopher
Zyda," below. Through the month of February 2004, Mr. Zyda's salary rate has
been $16.7 thousand per month (this rate is equivalent to an annualized rate
of $200 thousand per year, but is subject to reset each month).
(3) Mr. Zyda is entitled to a quarterly incentive bonus in the amount of 5% of
the incentive compensation payable to Seneca for such quarter. One-half of
each incentive bonus to Mr. Zyda will be payable in cash and one-half will
be payable in stock, as a restricted stock award under our 2003 stock
incentive plan. See "-- Employment Agreement with Christopher Zyda," below.
Amounts shown in the table above as bonus and stock awards for 2003 together
comprise Mr. Zyda's incentive bonus for the fourth quarter of 2003, which we
paid in early 2004. The total dollar amount of Mr. Zyda's fourth quarter
2003 incentive bonus was $30.3 thousand, for which we paid to Mr. Zyda $15.2
thousand in cash and issued to Mr. Zyda 1,283 shares of restricted stock.
Subject to Mr. Zyda's continued employment, these shares vest in three equal
annual installments beginning on February 4, 2005 (the first anniversary of
the date of grant).
(4) On August 4, 2003, we granted Mr. Zyda options to purchase 50 thousand
shares of our common stock at an exercise price of $15.00 per share. These
options vest in three equal annual installments beginning on the first
anniversary of the date of grant and expire 10 years after the date of
grant.
OPTION GRANTS
The following table describes the stock options we granted to our named
executive officers in 2003. The table also includes the potential realizable
value of these grants over the 10 year term of the options, based on assumed
rates of stock-price appreciation of 5% and 10%, compounded annually, from the
stated
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exercise price. These assumed rates of stock-price appreciation have been
selected in accordance with the rules of the SEC and do not represent an
estimate of our future stock price. We face the risk that our actual stock price
will not appreciate over the option terms at the assumed rates of 5% and 10%, or
at all. Unless the market price of the shares underlying each option increases
above the exercise price over the option term, the named executive officer will
not realize any value from the option grant. None of our named executive
officers has exercised any options to purchase our common stock.
OPTION GRANTS IN 2003
INDIVIDUAL GRANTS
-----------------------------------------------
NUMBER
OF POTENTIAL REALIZABLE VALUE
SECURITIES PERCENT AT ASSUMED ANNUAL RATES
UNDERLYING OF TOTAL OF STOCK PRICE APPRECIATION
OPTIONS OPTIONS FOR OPTION TERM
GRANTED GRANTED EXERCISE EXPIRATION ---------------------------
NAME 2003 IN 2003 PRICE DATE 5% 10%
---- ---------- -------- -------- ------------ ----------- -------------
Christopher J. Zyda.......... 50,000 91% $15.00 Aug. 4, 2013 $471,671 $1,195,307
Our compensation committee has the right to issue additional stock options
at any time.
EMPLOYMENT AGREEMENT WITH CHRISTOPHER ZYDA
We employ Mr. Zyda as our senior vice president and chief financial officer
pursuant to an employment agreement, which has been approved by our compensation
committee.
Base Salary. Mr. Zyda's base salary rate resets on the first day of each
month based upon our net worth on the final day of the preceding month. For
purposes of Mr. Zyda's employment agreement, our net worth is calculated in the
same manner as under our management agreement with Seneca. As of December 31,
2003, our net worth was approximately $282.5 million. Mr. Zyda's base salary is
as follows:
- if our net worth is less than $500 million at the end of any calendar
month, Mr. Zyda's base salary for the following month is 1/12th of $200
thousand;
- if our net worth is equal to or greater than $500 million, but less than
$1.0 billion, at the end of any calendar month, Mr. Zyda's base salary
for the following month is 1/12th of $250 thousand;
- if our net worth is equal to or greater than $1.0 billion, but less than
$1.5 billion, at the end of any calendar month, Mr. Zyda's base salary
for the following month is 1/12th of $300 thousand; and
- if our net worth is equal to or greater than $1.5 billion at the end of
any calendar month, Mr. Zyda's base salary for the following month is
1/12th of $500 thousand.
Incentive Bonus. Mr. Zyda is entitled to quarterly incentive bonus
payments under his employment agreement in an amount equal to 5% of Seneca's
incentive compensation for the quarter. Incentive bonuses are payable to Mr.
Zyda whenever Seneca or any successor manager receives (and has an unqualified
right to retain) any incentive compensation under the management agreement.
Seneca's right to incentive compensation is described under the caption "The
Manager -- The Management Agreement -- Management Compensation and Expenses."
The incentive bonus payable by us to Mr. Zyda is in addition to the incentive
compensation payable by us to Seneca.
One-half of each incentive bonus is payable to Mr. Zyda in cash and
one-half is payable in stock, in the form of a restricted stock award under our
2003 stock incentive plan. One-third of each such restricted stock award will
vest on each of the first three anniversaries of the date of issuance, subject
to Mr. Zyda's continued employment with us. Mr. Zyda will not be entitled to any
incentive bonus that becomes payable after the termination of his employment.
Mr. Zyda is not entitled to any incentive bonus in connection with any
termination fee payable to Seneca.
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Stock Options. On August 4, 2003, we granted Mr. Zyda options to purchase
50 thousand shares of our common stock under our 2003 stock incentive plan at an
exercise price of $15.00 per share. These options vest in three equal annual
installments beginning on the first anniversary of the date of grant and expire
10 years after the date of grant.
Termination. Mr. Zyda's employment period is for one year, with automatic
one-year renewals unless terminated earlier pursuant to the employment
agreement. Mr. Zyda may resign for any reason upon 30 days' prior written
notice. We may terminate Mr. Zyda's employment at any time. However, if we
terminate his employment prior to the end of the employment period without good
cause, or if Mr. Zyda resigns with good reason, we are required to pay him a
severance benefit equal to his annualized base salary in effect immediately
prior to the termination, payable within 60 days following the date of
termination.
- Mr. Zyda will have good reason to resign if we materially breach the
employment agreement, if we significantly diminish his aggregate
responsibilities, or if we relocate our executive offices more than 50
miles outside of San Francisco, California, among other reasons, but only
if we fail to correct such reasons within 10 days of a written complaint
from Mr. Zyda.
- We will have good cause to terminate Mr. Zyda's employment if our board
reasonably determines in good faith that Mr. Zyda acted negligently in
the performance of his material duties, was deliberately dishonest,
intentionally injured our company or its reputation, or breached any
fiduciary duty or any provision of his employment agreement, among other
actions specified in the employment agreement.
Non-Competition and Anti-Solicitation. The employment agreement provides
that Mr. Zyda may not aid any of our competitors during the employment period
and may not solicit any managerial employee or business contact of our company
or of Seneca during the employment period or for two years afterwards.
Binding Arbitration. Any dispute arising under the employment agreement is
subject to binding arbitration.
STOCK INCENTIVE PLANS
We have adopted a 2003 stock incentive plan and a 2003 outside advisors
stock incentive plan. The 2003 stock incentive plan provides for the grant of
the following types of awards:
- incentive stock options, or ISOs, that meet the requirements of Section
422 of the Internal Revenue Code;
- non-qualified stock options;
- stock appreciation rights (payable in cash or stock);
- restricted stock;
- stock units (payable in cash or stock) and other stock-based awards; and
- dividend equivalent rights, or DERs (payable in cash or stock).
The 2003 outside advisors plan provides for the grant of the same types of
awards as the 2003 stock incentive plan, except that ISOs may be granted only
under the 2003 stock incentive plan. The purpose of our 2003 stock incentive
plan is to provide a means of performance-based compensation to attract and
retain qualified personnel. The purpose of the 2003 outside advisors plan is to
provide an incentive to others whose job performance affects us.
Awards may be granted under our 2003 stock incentive plan to any of our
officers and key employees, if any, as well as to our directors and certain
consultants and advisors. ISOs, however, may be granted under the 2003 stock
incentive plan only to our officers and key employees, if any. Awards may be
granted under the 2003 outside advisors plan to Seneca and its directors,
officers, and key employees.
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Initially, 1,000,000 shares of our common stock in the aggregate will be
issuable upon exercise of awards granted under our 2003 stock incentive plan and
our 2003 outside advisors plan. Generally, shares of our common stock issued in
respect of awards granted under our 2003 stock incentive plan will reduce, on a
one-for-one basis, the number of shares remaining available under our 2003
outside advisors plan and vice versa.
If an option or other award granted under either of our stock incentive
plans expires or terminates, the shares subject to any portion of the award that
expires or terminates without having been exercised or paid, as the case may be,
will again become available for the issuance of additional awards. Awards that
are paid or settled in cash will not count against the share limits of the
plans. Unless previously terminated by our board of directors, no new award may
be granted under the 2003 stock incentive plan or under the 2003 outside
advisors plan after the tenth anniversary of the date that such plan was
initially approved by our board of directors. No award may be granted under
either of our stock incentive plans to any person who, assuming exercise of all
options and payment of all awards held by such person, would own or be deemed to
own more than 9.8% of the outstanding shares of our common stock.
Each of our stock incentive plans is administered by our board of directors
or a committee of the board. Initially, the plans will be administered by the
compensation committee of our board of directors, which is comprised entirely of
independent directors. Awards granted under our stock incentive plans will
become exercisable or payable, as the case may be, in accordance with the terms
of the grant made by the compensation committee. The compensation committee has
discretionary authority to determine the type(s) of awards to be granted, the
number of shares subject to each award, the purchase or exercise price of each
award or the shares of stock subject to the award, and when and in what
increments shares of our common stock covered by each award may be purchased. If
awards are to be granted to the independent directors, then our full board of
directors will approve such grants.
Each award must terminate or be paid no more than 10 years from the date it
is granted. Awards may be granted on terms providing that they will be
exercisable or payable in whole or in part at any time or times during their
respective terms, or only in specified percentages at stated time periods or
intervals during the term of the award.
Our compensation committee may permit the holder of an option or other
award to pay the exercise or purchase price of that award or the purchase price
of the shares of stock underlying the award:
- in cash;
- by surrender of shares of our common stock having a market value equal to
the aggregate purchase or exercise price of the shares to be purchased;
- by cancellation of indebtedness owed by us to the award holder;
- by a full-recourse promissory note executed by the award holder; or
- by any combination of the foregoing or other legal consideration.
The terms of the promissory note may be changed from time to time by our
board of directors or the compensation committee to comply with applicable
regulations or other relevant pronouncements of the IRS or the SEC.
Our board of directors may, without materially and adversely affecting any
outstanding awards, from time to time revise or amend our stock incentive plans,
and may suspend or discontinue them at any time. Stockholder approval for any
such amendment or revision will not be required except to the extent stockholder
approval is required as a matter of law.
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UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS
The following discussion summarizes the material U.S. federal income tax
considerations regarding our qualification and taxation as a REIT and the
material U.S. federal income tax consequences resulting from the acquisition,
ownership and disposition of our common stock. The following discussion is not
exhaustive of all possible tax considerations. This summary neither gives a
detailed discussion of any state, local or foreign tax considerations nor
discusses all of the aspects of U.S. federal income taxation that may be
relevant to you in light of your particular circumstances or to particular types
of stockholders which are subject to special tax rules, such as insurance
companies, tax-exempt entities, financial institutions or broker-dealers,
foreign corporations or partnerships, and persons who are not citizens or
residents of the United States, stockholders that hold our stock as a hedge,
part of a straddle, conversion transaction or other arrangement involving more
than one position, or stockholders whose functional currency is not the U.S.
dollar. This discussion assumes that you will hold our common stock as a
"capital asset," generally property held for investment, under the Internal
Revenue Code.
O'Melveny & Myers LLP has reviewed the discussion set forth below and is of
the opinion that the statements made in this discussion, to the extent such
statements summarize the material U.S. federal income tax consequences of the
beneficial ownership of stock, are correct in all material respects. The opinion
of O'Melveny & Myers LLP has been filed as an exhibit to this prospectus.
O'Melveny & Myers LLP's opinion is based on various assumptions, is subjection
to limitations, and is not binding on the Internal Revenue Service or any court.
The Internal Revenue Service may challenge the opinion of O'Melveny & Myers LLP,
and such a challenge could be successful.
This discussion and the opinions of O'Melveny & Myers LLP discussed herein
are based on current law. We cannot assure you that new laws, interpretations of
law or court decisions, any of which may take effect retroactively, will not
cause any statement in this section to be inaccurate.
YOU ARE URGED TO CONSULT WITH YOUR OWN TAX ADVISOR REGARDING THE SPECIFIC
CONSEQUENCES TO YOU OF THE PURCHASE, OWNERSHIP AND SALE OF STOCK IN AN ENTITY
ELECTING TO BE TAXED AS A REIT, INCLUDING THE FEDERAL, STATE, LOCAL, FOREIGN AND
OTHER TAX CONSIDERATIONS OF SUCH PURCHASE, OWNERSHIP, SALE AND ELECTION AND THE
POTENTIAL CHANGES IN APPLICABLE TAX LAWS.
GENERAL
We intend to make an election to be taxed as a REIT under the Internal
Revenue Code commencing with our taxable year ending December 31, 2003. In
connection with this offering, we have received the opinion of our legal
counsel, O'Melveny & Myers LLP, that commencing with our taxable year ending
December 31, 2003, we will be organized in conformity with the requirements for
qualification as a REIT under the Internal Revenue Code, and our proposed method
of operation will enable us to meet the requirements for qualification and
taxation as a REIT under the Internal Revenue Code. It must be emphasized that
this opinion is not binding on the IRS or any court. In addition, the opinion of
our counsel is based on various assumptions and is conditioned upon certain
representations made by us and by Seneca as to factual matters, including
factual representations concerning our business and assets as set forth in this
prospectus, and assumes that the actions described in this prospectus are
completed in a timely fashion.
Our qualification and taxation as a REIT depend on our ability to meet,
through actual annual operating results, distribution levels, diversity of stock
ownership, and the various other qualification tests imposed under the Internal
Revenue Code discussed below, the results of which will not be reviewed by
O'Melveny & Myers LLP. No assurance can be given that our actual results for any
particular taxable year will satisfy these requirements. See "-- Failure to
Qualify as a REIT." In addition, qualification as a REIT depends on future
transactions and events that cannot be known at this time.
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So long as we qualify for taxation as a REIT, we generally will be
permitted a deduction for dividends we pay to our stockholders. As a result, we
generally will not be required to pay federal corporate income taxes on our net
income that is currently distributed to our stockholders. This treatment
substantially eliminates the "double taxation" that ordinarily results from
investment in a corporation. Double taxation means taxation once at the
corporate level when income is earned and once again at the stockholder level
when this income is distributed. We will be required to pay U.S. federal income
tax, however, as follows:
- we will be required to pay tax at regular corporate rates on any
undistributed REIT taxable net income, including undistributed net
capital gain;
- we may be required to pay the "alternative minimum tax" on our items of
tax preference; and
- if we have (1) net income from the sale or other disposition of
"foreclosure property" which is held primarily for sale to customers in
the ordinary course of business or (2) other non-qualifying income from
foreclosure property, we will be required to pay tax at the highest
corporate rate on this income. Foreclosure property is generally defined
as property acquired through foreclosure or after a default on a loan
secured by the property or on a lease of the property.
We will be required to pay a 100% tax on any net income from prohibited
transactions. Prohibited transactions are, in general, sales or other taxable
dispositions of property, other than foreclosure property, held primarily for
sale to customers in the ordinary course of business. Under existing law,
whether property is held as inventory or primarily for sale to customers in the
ordinary course of a trade or business depends on all the facts and
circumstances surrounding the particular transaction.
If we fail to satisfy the 75% gross income test or the 95% gross income
test discussed below, but nonetheless maintain our qualification as a REIT
because certain other requirements are met, we will be subject to a tax equal
to:
- the greater of (1) the amount by which 75% of our gross income exceeds
the amount qualifying under the 75% gross income test described below,
and (2) the amount by which 90% of our gross income exceeds the amount
qualifying under the 95% gross income test described below, multiplied
by,
- a fraction intended to reflect our profitability.
We will be required to pay a 4% excise tax on the excess of the required
distribution over the amounts actually distributed if we fail to distribute
during each calendar year at least the sum of:
- 85% of our real estate investment trust ordinary income for the year;
- 95% of our real estate investment trust capital gain net income for the
year; and
- any undistributed taxable income from prior periods.
This distribution requirement is in addition to, and different from the
distribution requirements discussed below in the section entitled
"-- Distributions Generally."
If we acquire any asset from a corporation which is or has been taxed as a
C corporation under the Internal Revenue Code in a transaction in which the
basis of the asset in our hands is determined by reference to the basis of the
asset in the hands of the C corporation, and we subsequently recognize gain on
the disposition of the asset during the 10-year period beginning on the date on
which we acquired the asset, then we will be required to pay tax at the highest
regular corporate tax rate on this gain to the extent of the excess of:
- the fair market value of the asset, over
- our adjusted basis in the asset, in each case determined as of the date
on which we acquired the asset.
A C corporation is generally defined as a corporation required to pay full
corporate-level tax. The results described in this paragraph with respect to the
recognition of gain will apply unless we make an
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election under Treasury regulation Section 1.337(d)-7(c) to cause the C
corporation to recognize all of the gain inherent in the property at the time of
acquisition of the asset.
Finally, we could be subject to an excise tax if our dealings with any
taxable REIT subsidiaries are not at arm's length.
REQUIREMENTS FOR QUALIFICATION AS A REIT
The Internal Revenue Code defines a REIT as a corporation, trust or
association:
(i) that is managed by one or more trustees or directors;
(ii) that issues transferable shares or transferable certificates to
evidence beneficial ownership;
(iii) that would be taxable as a domestic corporation but for Sections 856
through 859 of the Internal Revenue Code;
(iv) that is not a financial institution or an insurance company within
the meaning of the Internal Revenue Code;
(v) that is beneficially owned by 100 or more persons;
(vi) not more than 50% in value of the outstanding stock of which is
owned, actually or constructively, by five or fewer individuals,
including specified entities, during the last half of each taxable
year; and
(vii) that meets other tests, described below, regarding the nature of its
income and assets and the amount of its distributions.
The Internal Revenue Code provides that all of the first four conditions
stated above must be met during the entire taxable year and that the fifth
condition must be met during at least 335 days of a taxable year of 12 months,
or during a proportionate part of a taxable year of less than 12 months. The
fifth and sixth conditions do not apply until after the first taxable year for
which an election is made to be taxed as a REIT.
STOCK OWNERSHIP TESTS
Our stock must be beneficially held by at least 100 persons, which we refer
to as the "100 stockholder rule," and no more than 50% of the value of our stock
may be owned, directly or indirectly, by five or fewer individuals at any time
during the last half of the taxable year, which we refer to as the "5/50 rule."
In determining whether five or fewer individuals hold our shares, certain
attribution rules of the Internal Revenue Code apply. For purposes of the 5/50
rule, pension trusts and other specific tax-exempt entities generally are
treated as individuals, except that certain tax-qualified pension funds are not
considered individuals and beneficiaries of such trusts are treated as holding
shares of a REIT in proportion to their actuarial interests in the trust for
purposes of the 5/50 rule. Our charter imposes repurchase provisions and
transfer restrictions to avoid having more than 50% of the value of our stock
being held by five or fewer individuals. These stock ownership requirements must
be satisfied in each taxable year other than the first taxable year for which an
election is made to be taxed as a REIT. We are required to solicit information
from certain of our record stockholders to verify actual stock ownership levels,
and our charter provides for restrictions regarding the transfer of our stock in
order to aid in meeting the stock ownership requirements. We will be treated as
satisfying the 5/50 rule if we comply with the demand letter and record keeping
requirements discussed below, and if we do not know, and by exercising
reasonable diligence would not have known, whether we failed to satisfy the 5/50
rule. We anticipate that we will satisfy the stock ownership tests immediately
following this offering, and will use reasonable efforts to monitor our stock
ownership in order to ensure continued compliance with these tests. If we were
to fail either of the stock ownership tests, we would generally be disqualified
from REIT status.
To monitor our compliance with the stock ownership tests, we are required
to maintain records regarding the actual ownership of our shares of stock. To do
so, we are required to demand written
93
statements each year from the record holders of certain percentages of our
shares of stock in which the record holders are to disclose the actual owners of
the shares (i.e., the persons required to include our dividends in gross
income). A REIT with 2,000 or more record stockholders must demand statements
from record holders of 5% or more of its shares, one with fewer than 2,000, but
more than 200, record stockholders must demand statements from record holders of
1% or more of the shares, while a REIT with 200 or fewer record stockholders
must demand statements from record holders of 0.5% or more of the shares. A list
of those persons failing or refusing to comply with this demand must be
maintained as part of our records. A stockholder who fails or refuses to comply
with the demand must submit a statement with his tax return disclosing the
actual ownership of the shares of stock and certain other information.
INCOME TESTS
We must satisfy two gross income requirements annually to maintain our
qualification as a REIT:
- under the "75% gross income test," we must derive at least 75% of our
gross income, excluding gross income from prohibited transactions, from
specified real estate sources, including rental income, interest on
obligations secured by mortgages on real property or on interests in real
property, gain from the disposition of "qualified real estate assets,"
i.e., interests in real property, mortgages secured by real property or
interests in real property, and some other assets, and income from
certain types of temporary investments; and
- under the "95% gross income test," we must derive at least 95% of our
gross income, excluding gross income from prohibited transactions, from
(1) the sources of income that satisfy the 75% gross income test, (2)
dividends, interest and gain from the sale or disposition of stock or
securities, including some interest rate swap and cap agreements,
options, futures and forward contracts entered into to hedge variable
rate debt incurred to acquire qualified real estate assets, or (3) any
combination of the foregoing.
For purposes of the 75% and 95% gross income tests, a REIT is deemed to
have earned a proportionate share of the income earned by any partnership, or
any limited liability company treated as a partnership for U.S. federal income
tax purposes, in which it owns an interest, which share is determined by
reference to its capital interest in such entity, and is deemed to have earned
the income earned by any qualified REIT subsidiary (in general, a 100% owned
corporate subsidiary of a REIT).
Any amount includable in our gross income with respect to a regular or
residual interest in a REMIC generally also is treated as interest on an
obligation secured by a mortgage on real property. If, however, less than 95% of
the assets of a REMIC consists of real estate assets (determined as if we held
such assets), we will be treated as receiving directly our proportionate share
of the income of the REMIC. In addition, if we receive interest income with
respect to a mortgage loan that is secured by both real property and other
property and the highest principal amount of the loan outstanding during a
taxable year exceeds the fair market value of the real property on the date we
became committed to make or purchase the mortgage loan, a portion of the
interest income, equal to (1) such highest principal amount minus such value,
divided by (2) such highest principal amount, generally will not be qualifying
income for purposes of the 75% gross income test. Interest income received with
respect to non-REMIC pay-through bonds and pass-through debt instruments, such
as collateralized mortgage obligations or CMOs, however, will not be qualifying
income for this purpose.
Interest earned by a REIT ordinarily does not qualify as income meeting the
75% or 95% gross income tests if the determination of all or some of the amount
of interest depends in any way on the income or profits of any person. Interest
will not be disqualified from meeting such tests, however, solely by reason of
being based on a fixed percentage or percentages of receipts or sales.
94
If we fail to satisfy one or both of the 75% or 95% gross income tests for
any taxable year, we may nevertheless qualify as a REIT for the year if we are
entitled to relief under the Internal Revenue Code. Generally, we may avail
ourselves of the relief provisions if:
- our failure to meet these tests was due to reasonable cause and not due
to willful neglect;
- we attach a schedule of the sources of our income to our U.S. federal
income tax return; and
- any incorrect information on the schedule was not due to fraud with
intent to evade tax.
If we are entitled to avail ourselves of the relief provisions, we will
maintain our qualification as a REIT but will be subject to certain penalty
taxes as described above. We may not, however, be entitled to the benefit of
these relief provisions in all circumstances. If these relief provisions do not
apply to a particular set of circumstances, we will not qualify as a REIT.
ASSET TESTS
At the close of each quarter of our taxable year, we must satisfy four
tests relating to the nature and diversification of our assets:
- at least 75% of the value of our total assets must be represented by
qualified real estate assets, cash, cash items and government securities;
- not more than 25% of our total assets may be represented by securities,
other than those securities included in the 75% asset test;
- of the investments included in the 25% asset class, the value of any one
issuer's securities may not exceed 5% of the value of our total assets,
and we generally may not own more than 10% by vote or value of any one
issuer's outstanding securities, in each case except with respect to
stock of any taxable REIT subsidiaries; and
- the value of the securities we own in any taxable REIT subsidiaries may
not exceed 20% of the value of our total assets.
Qualified real estate assets include interests in mortgages on real
property to the extent the principal balance of a mortgage does not exceed the
fair market value of the associated real property, regular or residual interests
in a REMIC (except that, if less than 95% of the assets of a REMIC consists of
"real estate assets" (determined as if we held such assets), we will be treated
as holding directly our proportionate share of the assets of such REMIC), and
shares of other REITs. Non-REMIC CMOs, however, do not qualify as qualified real
estate assets for this purpose.
A "taxable REIT subsidiary" is any corporation in which we own stock and as
to which we and such corporation jointly elect to treat such corporation as a
taxable REIT subsidiary. For purposes of the asset tests, we will be deemed to
own a proportionate share of the assets of any partnership, or any limited
liability company treated as a partnership for U.S. federal income tax purposes,
in which we own an interest, which share is determined by reference to our
capital interest in the entity, and will be deemed to own the assets owned by
any qualified REIT subsidiary and any other entity that is disregarded for U.S.
federal income tax purposes.
After initially meeting the asset tests at the close of any quarter, we
will not lose our status as a REIT for failure to satisfy the asset tests at the
end of a later quarter solely by reason of changes in asset values. If we fail
to satisfy the asset tests because we acquire securities or other property
during a quarter, we can cure this failure by disposing of sufficient
non-qualifying assets within 30 days after the close of that quarter. For this
purpose, an increase in our capital interest in any partnership or limited
liability company in which we own an interest will be treated as an acquisition
of a portion of the securities or other property owned by that partnership or
limited liability company.
We may at some point securitize mortgage loans and/or mortgage-backed
securities. If we were to securitize mortgage-related assets ourselves on a
regular basis (other than through the issuance of non-
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REMIC CMOs), there is a substantial risk that the securities could be "dealer
property" and that all of the profits from such sales would be subject to tax at
the rate of 100% as income from prohibited transactions. Accordingly, where we
intend to sell the securities created by that process, we expect that we will
engage in the securitization through one or more taxable REIT subsidiaries,
which will not be subject to this 100% tax. We also may securitize such
mortgage-related assets through the issuance of non-REMIC CMOs, whereby we
retain an equity interest in the mortgage-backed assets used as collateral in
the securitization transaction. The issuance of any such instruments could
result in a portion of our assets being classified as a taxable mortgage pool,
which would be treated as a separate corporation for U.S. federal income tax
purposes, which in turn could jeopardize our status as a REIT. We intend to
structure our securitizations in a manner that would not result in the creation
of taxable mortgage pool.
ANNUAL DISTRIBUTION REQUIREMENTS
To maintain our qualification as a REIT, we are required to distribute
dividends, other than capital gain dividends, to our stockholders in an amount
at least equal to:
- 90% of our REIT taxable net income, plus
- 90% of our after tax net income, if any, from foreclosure property, minus
- the excess of the sum of specified items of our non-cash income items
over 5% of REIT taxable net income, as described below.
For purposes of these distribution requirements, our REIT taxable net
income is computed without regard to the dividends paid deduction and net
capital gain. In addition, for purposes of this test, the specified items of
non-cash income include income attributable to leveled stepped rents, certain
original issue discount, certain like-kind exchanges that are later determined
to be taxable and income from cancellation of indebtedness. In addition, if we
disposed of any asset we acquired from a corporation which is or has been a C
corporation in a transaction in which our basis in the asset is determined by
reference to the basis of the asset in the hands of that C corporation and we
did not elect to recognize gain currently in connection with the acquisition of
such asset, we would be required to distribute at least 90% of the after-tax
gain, if any, we recognize on a disposition of the asset within the 10-year
period following our acquisition of such asset, to the extent that such gain
does not exceed the excess of:
- the fair market value of the asset on the date we acquired the asset,
over
- our adjusted basis in the asset on the date we acquired the asset.
Only distributions that qualify for the "dividends paid deduction"
available to REITs under the Internal Revenue Code are counted in determining
whether the distribution requirements are satisfied. We must make these
distributions in the taxable year to which they relate, or in the following
taxable year if they are declared before we timely file our tax return for that
year, paid on or before the first regular dividend payment following the
declaration and we elect on our tax return to have a specified dollar amount of
such distributions treated as if paid in the prior year. For these and other
purposes, dividends declared by us in October, November or December of one
taxable year and payable to a stockholder of record on a specific date in any
such month shall be treated as both paid by us and received by the stockholder
during such taxable year, provided that the dividend is actually paid by us by
January 31 of the following taxable year.
In addition, dividends distributed by us must not be preferential. If a
dividend is preferential, it will not qualify for the dividends paid deduction.
To avoid being preferential, every stockholder of the class of stock to which a
distribution is made must be treated the same as every other stockholder of that
class, and no class of stock may be treated other than according to its dividend
rights as a class.
To the extent that we do not distribute all of our net capital gain, or we
distribute at least 90%, but less than 100%, of our REIT taxable net income, as
adjusted, we will be required to pay tax on this undistributed income at regular
ordinary and capital gain corporate tax rates. Furthermore, if we fail to
distribute during each calendar year (or, in the case of distributions with
declaration and record dates
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falling in the last three months of the calendar year, by the end of the January
immediately following such year) at least the sum of (1) 85% of our REIT
ordinary income for such year, (2) 95% of our REIT capital gain income for such
year, and (3) any undistributed taxable income from prior periods, we will be
subject to a 4% nondeductible excise tax on the excess of such required
distribution over the amounts actually distributed. We intend to make timely
distributions sufficient to satisfy the annual distribution requirements.
Under certain circumstances, we may be able to rectify a failure to meet
the distribution requirements for a year by paying "deficiency dividends" to its
stockholders in a later year, which may be included in our deduction for
dividends paid for the earlier year. Although we may be able to avoid being
taxed on amounts distributed as deficiency dividends, we will be required to pay
to the IRS interest based upon the amount of any deduction taken for deficiency
dividends.
FAILURE TO QUALIFY AS A REIT
If we fail to qualify for taxation as a REIT in any taxable year, and the
relief provisions of the Internal Revenue Code do not apply, we will be required
to pay taxes, including any applicable alternative minimum tax, on our taxable
income in that taxable year and all subsequent taxable years at regular
corporate rates. Distributions to our stockholders in any year in which we fail
to qualify as a REIT will not be deductible by us and we will not be required to
distribute any amounts to our stockholders. As a result, we anticipate that our
failure to qualify as a REIT would reduce the cash available for distribution to
our stockholders. In addition, if we fail to qualify as a REIT, all
distributions to our stockholders will be taxable at ordinary income rates to
the extent of our current and accumulated earnings and profits. In this event,
corporate distributees may be eligible for the dividends-received deduction.
Unless entitled to relief under specific statutory provisions, we will also be
disqualified from taxation as a REIT for the four taxable years following the
year in which we lose our qualification.
TAXATION OF TAXABLE UNITED STATES STOCKHOLDERS
For purposes of the discussion in this prospectus, the term "United States
stockholder" means a beneficial holder of our stock that is, for U.S. federal
income tax purposes:
- a citizen or resident of the United States (as determined for U.S.
federal income tax purposes);
- a corporation, partnership, or other entity created or organized in or
under the laws of the United States or of any state thereof or in the
District of Columbia, unless Treasury regulations provide otherwise;
- an estate the income of which is subject to U.S. federal income taxation
regardless of its source; or
- a trust whose administration is subject to the primary supervision of a
U.S. court and which has one or more U.S. persons who have the authority
to control all substantial decisions of the trust.
DISTRIBUTIONS GENERALLY
Distributions out of our current or accumulated earnings and profits, other
than capital gain dividends, will be taxable to United States stockholders as
ordinary dividends. Such REIT dividends generally are ineligible for the new
reduced 15% tax rate for dividends received by individuals, trusts and estates.
However, such rate will apply to the extent that we make distributions
attributable to amounts, if any, we receive as dividends from non-REIT
corporations or to the extent that we make distributions attributable to income
that was subject to tax at the REIT level. Provided that we qualify as a REIT,
dividends paid by us will not be eligible for the dividends received deduction
generally available to United States stockholders that are corporations. To the
extent that we make distributions in excess of current and accumulated earnings
and profits, the distributions will be treated as a tax-free return of capital
to each United States stockholder, and will reduce the adjusted tax basis that
each United States stockholder has in our stock by the amount of the
distribution, but not below zero. Distributions in excess of a United States
stockholder's adjusted tax basis in its stock will be taxable as capital gain,
and will be taxable as
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long-term capital gain if the stock has been held for more than one year. The
calculation of the amount of distributions that are applied against or exceed
adjusted tax basis are made on a share-by-share basis. To the extent that we
make distributions, if any, that are attributable to excess inclusion income,
such amounts may not be offset by net operating losses of a United States
stockholder. If we declare a dividend in October, November, or December of any
calendar year which is payable to stockholders of record on a specified date in
such a month and actually pay the dividend during January of the following
calendar year, the dividend is deemed to be paid by us and received by the
stockholder on December 31st of the year preceding the year of payment.
Stockholders may not include in their own income tax returns any of our net
operating losses or capital losses.
CAPITAL GAIN DISTRIBUTIONS
Distributions designated by us as capital gain dividends will be taxable to
United States stockholders as capital gain income. We can designate
distributions as capital gain dividends to the extent of our net capital gain
for the taxable year of the distribution. For tax years prior to 2009, this
capital gain income will generally be taxable to non-corporate United States
stockholders at a 15% or 25% rate based on the characteristics of the asset we
sold that produced the gain. United States stockholders that are corporations
may be required to treat up to 20% of certain capital gain dividends as ordinary
income.
RETENTION OF NET CAPITAL GAINS
We may elect to retain, rather than distribute as a capital gain dividend,
our net capital gains. If we were to make this election, we would pay tax on
such retained capital gains. In such a case, our stockholders would generally:
- include their proportionate share of our undistributed net capital gains
in their taxable income;
- receive a credit for their proportionate share of the tax paid by us in
respect of such net capital gain; and
- increase the adjusted basis of their stock by the difference between the
amount of their share of our undistributed net capital gain and their
share of the tax paid by us.
PASSIVE ACTIVITY LOSSES, INVESTMENT INTEREST LIMITATIONS AND OTHER
CONSIDERATIONS OF HOLDING OUR STOCK
Distributions we make, undistributed net capital gain includible in income
and gains arising from the sale or exchange of our stock by a United States
stockholder will not be treated as passive activity income. As a result, United
States stockholders will not be able to apply any "passive losses" against
income or gains relating to our stock. Distributions by us, to the extent they
do not constitute a return of capital, and undistributed net capital gain
includible in our stockholders' income, generally will be treated as investment
income for purposes of computing the investment interest limitation under the
Internal Revenue Code, provided the proper election is made.
If we, or a portion of our assets, were to be treated as a taxable mortgage
pool, or if we were to acquire REMIC residual interests, our stockholders (other
than certain thrift institutions) may not be permitted to offset certain
portions of the dividend income they derive from our shares with their current
deductions or net operating loss carryovers or carrybacks. The portion of a
stockholder's dividends that will be subject to this limitation will equal the
allocable share of our "excess inclusion income."
DISPOSITIONS OF STOCK
A United States stockholder that sells or disposes of our stock will
recognize gain or loss for federal income tax purposes in an amount equal to the
difference between the amount of cash or the fair market value of any property
the stockholder receives on the sale or other disposition and the stockholder's
adjusted tax basis in the stock. This gain or loss generally will be capital
gain or loss and will be long-term capital gain or loss if the stockholder has
held the stock for more than one year. However, any loss recognized by a United
States stockholder upon the sale or other disposition of our stock that the
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stockholder has held for six months or less will be treated as long-term capital
loss to the extent the stockholder received distributions from us which were
required to be treated as long-term capital gains. For tax years prior to 2009,
capital gain of an individual United States stockholder is generally taxed at a
maximum rate of 15% where the property is held for more than one year. The
deductibility of capital loss is limited.
INFORMATION REPORTING AND BACKUP WITHHOLDING
We report to our United States stockholders and the IRS the amount of
dividends paid during each calendar year, along with the amount of any tax
withheld. Under the backup withholding rules, a stockholder may be subject to
backup withholding with respect to dividends paid and redemption proceeds unless
the holder is a corporation or comes within other exempt categories and, when
required, demonstrates this fact, or provides a taxpayer identification number
or social security number, certifying as to no loss of exemption from backup
withholding, and otherwise complies with applicable requirements of the backup
withholding rules. A United States stockholder that does not provide. us with
its correct taxpayer identification number or social security number may also be
subject to penalties imposed by the IRS. A United States stockholder can meet
this requirement by providing us with a correct, properly completed and executed
copy of IRS Form W-9 or a substantially similar form. Backup withholding is not
an additional tax. Any amount paid as backup withholding will be creditable
against the stockholder's income tax liability, if any, and otherwise be
refundable, provided the proper forms are filed on a timely basis. In addition,
we may be required to withhold a portion of capital gain distributions made to
any stockholders who fail to certify their non-foreign status. The backup
withholding tax rate currently is 28%.
TAXATION OF TAX-EXEMPT STOCKHOLDERS
The IRS has ruled that amounts distributed as a dividend by a REIT will be
treated as a dividend by the recipient and excluded from the calculation of
unrelated business taxable income when received by a tax-exempt entity. Based on
that ruling, provided that a tax-exempt stockholder has not held our stock as
"debt financed property" within the meaning of the Internal Revenue Code, i.e.,
property the acquisition or holding of which is or is treated as financed
through a borrowing by the tax-exempt United States stockholder, the stock is
not otherwise used in an unrelated trade or business, and we do not hold an
asset that gives rise to "excess inclusion" income, as defined in Section 860E
of the Internal Revenue Code, dividend income on our stock and income from the
sale of our stock should not be unrelated business taxable income to a
tax-exempt stockholder. However, if we were to hold residual interests in a
REMIC, or if we or a pool of our assets were to be treated as a taxable mortgage
pool, a portion of the dividends paid to a tax-exempt stockholder may be subject
to tax as unrelated business taxable income. Although we do not believe that we,
or any portion of our assets, will be treated as a taxable mortgage pool, we
cannot assure you that that the IRS might not successfully maintain that such a
taxable mortgage pool exists.
For tax-exempt stockholders that are social clubs, voluntary employees'
beneficiary associations, supplemental unemployment benefit trusts, and
qualified group legal services plans exempt from U.S. federal income taxation
under Sections 501(c)(7), (c)(9), (c)(17) and (c)(20) of the Internal Revenue
Code, respectively, income from an investment in our stock will constitute
unrelated business taxable income unless the organization is able to properly
claim a deduction for amounts set aside or placed in reserve for certain
purposes so as to offset the income generated by its investment in our stock.
Any prospective investors should consult their tax advisors concerning these
"set aside" and reserve requirements.
Notwithstanding the above, however, a substantial portion of the dividends
received with respect to our stock may constitute unrelated business taxable
income, or UBTI, if we are treated as a "pension-held REIT" and you are a
pension trust which:
- is described in Section 401(a) of the Internal Revenue Code; and
- holds more than 10%, by value, of our equity interests.
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Tax-exempt pension funds that are described in Section 401(a) of the
Internal Revenue Code and exempt from tax under Section 501(a) of the Internal
Revenue Code are referred to below as "qualified trusts."
A REIT is a "pension-held REIT" if:
- it would not have qualified as a REIT but for the fact that Section
856(h)(3) of the Internal Revenue Code provides that stock owned by a
qualified trust shall be treated, for purposes of the 5/50 rule,
described above, as owned by the beneficiaries of the trust, rather than
by the trust itself; and
- either at least one qualified trust holds more than 25%, by value, of the
interests in the REIT, or one or more qualified trusts, each of which
owns more than 10%, by value, of the interests in the REIT, holds in the
aggregate more than 50%, by value, of the interests in the REIT.
The percentage of any REIT dividends treated as unrelated business taxable
income under these rules is equal to the ratio of:
- the unrelated business taxable income earned by the REIT, less directly
related expenses, treating the REIT as if it were a qualified trust and
therefore subject to tax on unrelated business taxable income, to
- the total gross income, less directly related expenses, of the REIT.
A de minimis exception applies where this percentage is less than 5% for
any year. As a result of the limitations on the transfer and ownership of stock
contained in our charter, we do not expect to be classified as a pension-held
REIT.
TAXATION OF NON-UNITED STATES STOCKHOLDERS
The rules governing U.S. federal income taxation of non-United States
stockholders are complex and no attempt will be made herein to provide more than
a summary of these rules. "Non-United States stockholders" mean beneficial
owners of shares of our stock that are not United States stockholders (as such
term is defined in the discussion above under the heading entitled "Taxation of
Taxable United States Stockholders").
PROSPECTIVE NON-U.S. STOCKHOLDERS SHOULD CONSULT THEIR TAX ADVISORS TO
DETERMINE THE IMPACT OF FOREIGN, FEDERAL, STATE, AND LOCAL INCOME TAX LAWS WITH
REGARD TO AN INVESTMENT IN OUR STOCK AND OF OUR ELECTION TO BE TAXED AS A REAL
ESTATE INVESTMENT TRUST, INCLUDING ANY REPORTING REQUIREMENTS.
Distributions to non-United States stockholders that are not attributable
to gain from our sale or exchange of U.S. real property interests and that are
not designated by us as capital gain dividends or retained capital gains will be
treated as dividends of ordinary income to the extent that they are made out of
our current or accumulated earnings and profits. These distributions will
generally be subject to a withholding tax equal to 30% of the distribution
unless an applicable tax treaty reduces or eliminates that tax. However, if
income from an investment in our stock is treated as effectively connected with
the non-United States stockholder's conduct of a U.S. trade or business (or, if
an income tax treaty applies, is attributable to a U.S. permanent establishment
of the non-United States stockholder), the non-United States stockholder
generally will be subject to federal income tax at graduated rates in the same
manner as United States stockholders are taxed with respect to those
distributions, and also may be subject to the 30% branch profits tax in the case
of a non-United States stockholder that is a corporation, unless a treaty
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reduces or eliminates these taxes. We expect to withhold-tax at the rate of 30%
on the gross amount of any distributions made to a non-United States stockholder
unless:
- a lower treaty rate applies and any required form, for example IRS Form
W-8BEN, evidencing eligibility for that reduced rate is filed by the
non-United States stockholder with us; or
- the non-United States stockholder files an IRS Form W-8ECI with us
claiming that the distribution is effectively connected income.
Any portion of the dividends paid to non-United States stockholders that is
treated as excess inclusion income will not be eligible for exemption from the
30% withholding tax or a reduced treaty rate.
Distributions in excess of our current and accumulated earnings and profits
that are not treated as attributable to the gain from our disposition of a U.S.
real property interest will not be taxable to non-United States stockholders to
the extent that these distributions do not exceed the adjusted basis of the
stockholder's stock, but rather will reduce the adjusted basis of that stock. To
the extent that distributions in excess of current and accumulated earnings and
profits exceed the adjusted basis of a non-United States stockholder's stock,
these distributions will give rise to tax liability if the non-United States
stockholder would otherwise be subject to tax on any gain from the sale or
disposition of its stock, as described below. Because it generally cannot be
determined at the time a distribution is made whether or not such distribution
may be in excess of current and accumulated earnings and profits, the entire
amount of any distribution normally will be subject to withholding at the same
rate as a dividend. However, amounts so withheld are creditable against U.S. tax
liability, if any, or refundable by the IRS to the extent the distribution is
subsequently determined to be in excess of our current and accumulated earnings
and profits and the proper forms are filed with the IRS by the stockholder on a
timely basis. We are also required to withhold 10% of any distribution in excess
of our current and accumulated earnings and profits if our stock is a U.S. real
property interest because we are not a domestically controlled REIT, as
discussed below. Consequently, although we intend to withhold at a rate of 30%
on the entire amount of any distribution, to the extent that we do not do so,
any portion of a distribution not subject to withholding at a rate of 30% may be
subject to withholding at a rate of 10%.
Distributions attributable to our capital gains which are not attributable
to gain from the sale or exchange of a U.S. real property interest generally
will not be subject to income taxation, unless (1) investment in our stock is
effectively connected with the non-United States stockholder's U.S. trade or
business (or, if an income tax treaty applies, is attributable to a U.S.
permanent establishment of the non-United States stockholder), in which case the
non-United States stockholder will be subject to the same treatment as United
States stockholders with respect to such gain (and a corporate non-United States
stockholder may also be subject to the 30% branch profits tax), or (2) the
non-United States stockholder is a non-resident alien individual who is present
in the U.S. for 183 days or more during the taxable year and certain other
conditions are satisfied, in which case the non-resident alien individual will
be subject to a 30% tax on the individual's capital gains.
For any year in which we qualify as a REIT, distributions that are
attributable to gain from the sale or exchange of a U.S. real property interest,
which includes some interests in real property, but generally does not include
an interest solely as a creditor in mortgage loans or mortgage-backed
securities, will be taxed to a non-United States stockholder under the
provisions of the Foreign Investment in Real Property Tax Act, or FIRPTA. Under
FIRPTA, distributions attributable to gain from sales of U.S. real property
interests are taxed to a non-United States stockholder as if that gain were
effectively connected with the stockholder's conduct of a U.S. trade or
business. Non-United States stockholders thus would be taxed at the normal
capital gain rates applicable to United States stockholders, subject to
applicable alternative minimum tax and a special alternative minimum tax in the
case of nonresident alien individuals. Distributions subject to FIRPTA also may
be subject to the 30% branch profits tax in the hands of a non-U.S. corporate
stockholder. We are required to withhold 35% of any distribution paid to a
non-United States stockholder that we designate (or, if greater, the amount that
we could designate) as a capital gains dividend. The amount withheld is
creditable against the non-United States stockholder's FIRPTA tax liability,
provided the proper forms are filed on a timely basis.
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Gains recognized by a non-United States stockholder upon a sale of our
stock generally will not be taxed under FIRPTA if we are a domestically
controlled REIT, which is a REIT in which at all times during a specified
testing period less than 50% in value of the stock was held directly or
indirectly by non-United States stockholders. Because our stock is publicly
traded/widely held, we cannot assure our investors that we are or will remain a
domestically controlled REIT. Even if we are not a domestically controlled REIT,
however, a non-United States stockholder that owns, actually or constructively,
5% or less of our stock throughout a specified testing period will not recognize
taxable gain on the sale of our stock under FIRPTA if our shares are traded on
an established securities market.
If gain from the sale of the stock were subject to taxation under FIRPTA,
the non-United States stockholder would be subject to the same treatment as
United States stockholders with respect to that gain, subject to applicable
alternative minimum tax, a special alternative minimum tax in the case of
nonresident alien individuals, and the possible application of the 30% branch
profits tax in the case of non-U.S. corporations. In addition, the purchaser of
the stock could be required to withhold 10% of the purchase price and remit such
amount to the IRS.
Gains not subject to FIRPTA will be taxable to a non-United States
stockholder if the non-United States stockholder's investment in the stock is
effectively connected with a trade or business in the U.S. (or, if an income tax
treaty applies, is attributable to a U.S. permanent establishment of the
non-United States stockholder), in which case the non-United States stockholder
will be subject to the same treatment as United States stockholders with respect
to that gain; or the non-United States stockholder is a nonresident alien
individual who was present in the U.S. for 183 days or more during the taxable
year and other conditions are met, in which case the nonresident alien
individual will be subject to a 30% tax on the individual's capital gains.
INFORMATION REPORTING AND BACKUP WITHHOLDING FOR NON-UNITED STATES STOCKHOLDERS
If the proceeds of a disposition of our stock are paid by or through a U.S.
office of a broker-dealer, the payment is generally subject to information
reporting and to backup withholding (currently at a rate of 28%) unless the
disposing non-United States stockholder certifies as to his name, address and
non-U.S. status or otherwise establishes an exemption. Generally, U.S.
information reporting and backup withholding will not apply to a payment of
disposition proceeds if the payment is made outside the U.S. through a foreign
office of a foreign broker-dealer. If the proceeds from a disposition of our
stock are paid to or through a foreign office of a U.S. broker-dealer or a
non-U.S. office of a foreign broker-dealer that is (1) a "controlled foreign
corporation" for U.S. federal income tax purposes, (2) a foreign person 50% or
more of whose gross income from all sources for a three-year period was
effectively connected with a U.S. trade or business, (3) a foreign partnership
with one or more partners who are U.S. persons and who in the aggregate hold
more than 50% of the income or capital interest in the partnership, or (4) a
foreign partnership engaged in the conduct of a trade or business in the U.S.,
then (a) backup withholding will not apply unless the broker-dealer has actual
knowledge that the owner is not a foreign stockholder, and (b) information
reporting will not apply if the non-United States stockholder satisfies
certification requirements regarding its status as a foreign stockholder. Other
information reporting rules apply to non-United States stockholders, and
prospective non-United States stockholders should consult their own tax advisors
regarding these requirements.
NEW LEGISLATION AND POSSIBLE LEGISLATIVE OR OTHER ACTION AFFECTING TAX
CONSEQUENCES
Recently enacted legislation reduced the maximum tax rate of non-corporate
taxpayers for capital gains generally from 20% to 15% (for taxable years ending
on or after May 6, 2003 and before January 1, 2009) and for dividends payable to
non-corporate taxpayers generally from 38.6% to 15% (for taxable years beginning
after December 31, 2002 and before January 1, 2009). As discussed above at
"-- Taxation of Taxable United States Stockholders -- Distributions Generally,"
dividends paid by REITs are generally not eligible for the new 15% federal
income tax rate, with certain exceptions. Although this legislation does not
adversely affect the taxation of REITs or dividends paid by REITs, the more
favorable treatment of regular corporate dividends could cause investors who are
individuals to consider stocks of other
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corporations that pay dividends as more attractive relative to stocks of REITs.
It is not possible to predict whether this change in perceived relative value
will occur, or what the effect will be on the market price of our stock.
You should recognize that the present U.S. federal income tax treatment of
an investment in us may be modified by legislative, judicial or administrative
action at any time and that any such action may affect investments and
commitments previously made. The rules dealing with U.S. federal income taxation
are constantly under review by persons involved in the legislative process and
by the Internal Revenue Service and the Treasury Department, resulting in
revisions of regulations and revised interpretations of established concepts as
well as statutory changes. Revisions in federal tax laws and interpretations
thereof could affect the tax consequences of an investment in us.
In particular, legislation was recently introduced in both the United
States House of Representatives and the United States Senate that would amend
certain rules relating to REITs. Among other changes, the proposed legislation
would provide the Internal Revenue Service with the ability to impose monetary
penalties, rather than a loss of REIT status, for reasonable cause violations of
certain tests relating to REIT qualification. The proposed legislation would
also change the formula for calculating the tax imposed for certain violations
of the 75% and 95% gross income tests discussed above at "-- Requirements for
Qualification as a REIT -- Income Tests." In general, the changes would apply to
taxable years beginning after the date the legislation is enacted. As of the
date hereof, this legislation has not been enacted into law, and it is not
possible to predict with any certainty whether the proposed legislation will be
enacted in its current form.
STATE, LOCAL AND FOREIGN TAXATION
We may be required to pay state, local and foreign taxes in various state,
local and foreign jurisdictions, including those in which we transact business
or make investments, and our stockholders may be required to pay state, local
and foreign taxes in various state, local and foreign jurisdictions, including
those in which they reside. Our state, local and foreign tax treatment may not
conform to the federal income tax consequences summarized above. In addition, a
stockholder's state, local and foreign tax treatment may not conform to the
federal income tax consequences summarized above. Consequently, prospective
investors should consult their tax advisors regarding the effect of state, local
and foreign tax laws on an investment in our stock.
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DESCRIPTION OF CAPITAL STOCK
The following summary highlights the material information about our capital
stock. You should refer to our charter and our bylaws for a full description.
Copies of our charter and our bylaws are filed as exhibits to the registration
statement of which this prospectus is a part. You can also obtain copies of our
charter and our bylaws and every other exhibit to our registration statement.
Please see "Where You Can Find More Information about Luminent Mortgage Capital"
on page 121 below.
GENERAL
Our charter provides that we may issue up to 100,000,000 shares of our
common stock, $0.001 par value per share, and 10,000,000 shares of our preferred
stock, $0.001 par value per share. As of March 29, 2004, we had 24,841,146
shares of our common stock issued and outstanding and no shares of our preferred
stock issued and outstanding. As of March 29, 2004, the number of record holders
of our common stock was 17. The 17 holders of record include Cede & Co., which
holds shares as nominee for The Depository Trust Company, which itself holds
shares on behalf of hundreds of beneficial owners of our common stock. Under
Maryland law, stockholders generally are not liable for the corporation's debts
or obligations.
COMMON STOCK
All shares of our common stock offered hereby have been duly authorized
and, upon issuance in exchange for the price thereof, will be validly issued,
fully paid and non-assessable. Subject to the preferential rights of any other
class or series of stock and to the provisions of our charter regarding the
restrictions on transfer of stock, holders of shares of our common stock are
entitled to receive dividends on such stock if, as and when authorized and
declared by our board of directors out of assets legally available therefor and
to share ratably in our assets legally available for distribution to our
stockholders in the event of our liquidation, dissolution or winding up after
payment of or adequate provision for all our known debts and liabilities.
Subject to the provisions of our charter regarding the restrictions on
ownership and transfer of stock and the terms of any other class or series of
our stock, each outstanding share of our common stock entitles the holder to one
vote on all matters submitted to a vote of stockholders, including the election
of directors and, except as provided with respect to any other class or series
of our stock, the holders of such shares of our common stock possess the
exclusive voting power. There is no cumulative voting in the election of our
directors, which means that the holders of a majority of the outstanding shares
of our common stock elect all of the directors then standing for election and
the holders of the remaining shares are not able to elect any of our directors.
Holders of shares of our common stock have no preference, conversion,
exchange, sinking fund, or redemption and have no preemptive rights to subscribe
for any of our securities. Subject to the provisions of our charter regarding
the restrictions on ownership transfer of stock, shares of our common stock have
equal dividend, liquidation and other rights.
Under the MGCL, a Maryland corporation generally cannot dissolve, amend its
charter, merge, sell all or substantially all of its assets, engage in a share
exchange or engage in similar transactions outside the ordinary course of
business unless approved by the affirmative vote of stockholders holding at
least two-thirds of the shares entitled to vote on the matter, unless a lesser
percentage (but not fewer than a majority of all of the votes entitled to be
cast by the stockholders on the matter) is set forth in the corporation's
charter. Our charter provides that any such action shall be effective and valid
if taken or authorized by our stockholders by the affirmative vote of a majority
of all the votes entitled to be cast on the matter, except that amendments to
the provisions of our charter relating to the removal of directors must be
approved by our stockholders by the affirmative vote of at least two-thirds of
the votes entitled to be cast on the matter.
Our charter authorizes our board of directors to reclassify any unissued
shares of our common stock into other classes or series of classes of our stock,
to establish the number of shares in each class or series
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and to set the preferences, conversion and other rights, voting powers,
restrictions, limitations as to dividends or other distributions, qualifications
or terms or conditions of redemption for each such class or series.
PREFERRED STOCK
Our charter authorizes our board of directors to classify any unissued
shares of preferred stock and to reclassify any previously classified but
unissued shares of any series of preferred stock previously classified by our
board of directors. Prior to issuance of shares of each class or series of
preferred stock, our board is required by the MGCL and our charter to fix the
terms, preferences, conversion or other rights, voting powers, restrictions,
limitations as to dividends or other distributions, qualifications and terms or
conditions of redemption for each such class or series. Thus, our board could
authorize the issuance of shares of preferred stock with terms and conditions
which could have the effect of delaying, deferring or preventing a transaction
or a change of control that might involve a premium price for holders of our
common stock or otherwise be in their best interest. As of the closing of the
offering, no shares of our preferred stock will be outstanding and we have no
present plans to issue any preferred stock.
POWER TO ISSUE ADDITIONAL SHARES OF OUR COMMON STOCK AND PREFERRED STOCK
We believe that the power of our board of directors to issue additional
authorized but unissued shares of our common stock or preferred stock and to
classify or reclassify unissued shares of our common or preferred stock and
thereafter to cause us to issue such classified or reclassified shares of stock
will provide us with increased flexibility in structuring possible future
financings and acquisitions and in meeting other needs which might arise. The
additional classes or series, as well as our common stock, are available for
issuance without further action by our stockholders, unless such action is
required by applicable law or the rules of any stock exchange or automated
quotation system on which our securities may be listed or traded. Although our
board of directors has no intention at the present time of doing so, it could
authorize us to issue a class or series that could, depending upon the terms of
such class or series, delay, defer or prevent a transaction or a change in
control of us that might involve a premium price for holders of our common stock
or otherwise be in their best interest.
TRANSFER RESTRICTIONS
Our charter, subject to certain exceptions, contains certain restrictions
on the number of shares of our stock that a person may own. Our charter contains
a stock ownership limit which will prohibit any person from acquiring or
holding, directly or indirectly, shares of stock in excess of 9.8% of the lesser
of the total number or value of any class of our stock. Our board of directors,
in its sole discretion, may exempt a person from the stock ownership limit.
However, our board of directors may not grant such an exemption to any person
whose ownership, direct or indirect, of in excess of 9.8% of the lesser of the
number or value of the outstanding shares of our stock would result in us being
"closely held" within the meaning of Section 856(h) of the Internal Revenue Code
or otherwise would result in us failing to qualify as a REIT. The person seeking
an exemption must represent to the satisfaction of our board of directors that
it will not violate the aforementioned restriction. The person also must agree
that any violation or attempted violation of any of the foregoing restriction
will result in the automatic transfer of the shares of stock causing such
violation to the trust (as defined below). Our board of directors may require a
ruling from the IRS or an opinion of counsel, in either case in form and
substance satisfactory to our board of directors in its sole discretion, in
order to determine or ensure our status as a REIT.
Our charter further prohibits:
- any person from beneficially or constructively owning shares of our stock
that would result in us being "closely held" under Section 856(h) of the
Internal Revenue Code or otherwise cause us to fail to qualify as a REIT;
and
- any person from transferring shares of our stock if such transfer would
result in shares of our stock being owned by fewer than 100 persons.
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Any person who acquires or attempts or intends to acquire beneficial or
constructive ownership of shares of our stock that will or may violate any of
the foregoing restrictions on transferability and ownership, or any person who
would have owned shares of our stock that resulted in a transfer of shares to
the trust in the manner described below, will be required to give notice
immediately to us and provide us with such other information as we may request
in order to determine the effect of such transfer on us.
If any transfer of shares of our stock occurs which, if effective, would
result in any person beneficially or constructively owning shares of our stock
in excess or in violation of the above transfer or ownership limitations, then
that number of shares of our stock the beneficial or constructive ownership of
which otherwise would cause such person to violate such limitations (rounded to
the nearest whole share) shall be automatically transferred to a trust for the
exclusive benefit of one or more charitable beneficiaries, and the prohibited
owner shall not acquire any rights in such shares. Such automatic transfer shall
be deemed to be effective as of the close of business on the business day prior
to the date of such violative transfer. Shares of stock held in the trust shall
be issued and outstanding shares of our stock. The prohibited owner shall not
benefit economically from ownership of any shares of stock held in the trust,
shall have no rights to dividends and shall not possess any rights to vote or
other rights attributable to the shares of stock held in the trust. The trustee
of the trust shall have all voting rights and rights to dividends or other
distributions with respect to shares of stock held in the trust, which rights
shall be exercised for the exclusive benefit of the charitable beneficiary. Any
dividend or other distribution paid prior to the discovery by us that shares of
stock have been transferred to the trustee shall be paid by the recipient of
such dividend or distribution to the trustee upon demand, and any dividend or
other distribution authorized but unpaid shall be paid when due to the trustee.
Any dividend or distribution so paid to the trustee shall be held in trust for
the charitable beneficiary. The prohibited owner shall have no voting rights
with respect to shares of stock held in the trust and, subject to Maryland law,
effective as of the date that such shares of stock have been transferred to the
trust, the trustee shall have the authority (at the trustee's sole discretion):
- to rescind as void any vote cast by a prohibited owner prior to the
discovery by us that such shares have been transferred to the trust; and
- to recast such vote in accordance with the desires of the trustee acting
for the benefit of the charitable beneficiary. However, if we have
already taken irreversible corporate action, then the trustee shall not
have the authority to rescind and recast such vote.
Within 20 days after receiving notice from us that shares of our stock have
been transferred to the trust, the trustee shall sell the shares of stock held
in the trust to a person, designated by the trustee, whose ownership of the
shares will not violate any of the ownership limitations set forth in our
charter. Upon such sale, the interest of the charitable beneficiary in the
shares sold shall terminate and the trustee shall distribute the net proceeds of
the sale to the prohibited owner and to the charitable beneficiary as follows.
The prohibited owner shall receive the lesser of:
- the price paid by the prohibited owner for the shares or, if the
prohibited owner did not give value for the shares in connection with the
event causing the shares to be held in the trust (e.g., a gift, devise or
other such transaction), the market price, as defined in our charter, of
such shares on the day of the event causing the shares to be held in the
trust; and
- the price per share received by the trustee from the sale or other
disposition of the shares held in the trust, in each case reduced by the
costs incurred to enforce the ownership limits as to the shares in
question. Any net sale proceeds in excess of the amount payable to the
prohibited owner shall be paid immediately to the charitable beneficiary.
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If, prior to the discovery by us that shares of our stock have been
transferred to the trust, such shares are sold by a prohibited owner, then:
- such shares shall be deemed to have been sold on behalf of the trust; and
- to the extent that the prohibited owner received an amount for such
shares that exceeds the amount that such prohibited owner was entitled to
receive pursuant to the aforementioned requirement, such excess shall be
paid to the trustee upon demand.
In addition, shares of our stock held in the trust shall be deemed to have
been offered for sale to us, or our designee, at a price per share equal to the
lesser of:
- the price per share in the transaction that resulted in such transfer to
the trust (or, in the case of a devise or gift, the market price at the
time of such devise or gift); and
- the market price on the date we, or our designee, accept such offer.
We shall have the right to accept such offer until the trustee has sold the
shares of stock held in the trust. Upon such a sale to us, the interest of the
charitable beneficiary in the shares sold shall terminate and the trustee shall
distribute the net proceeds of the sale to the prohibited owner.
All certificates representing shares of our common stock and preferred
stock, if issued, will bear a legend referring to the restrictions described
above.
Every owner of more than 1% (or such lower percentage as required by the
Internal Revenue Code or the related regulations) of all classes or series of
our stock, including shares of our common stock, within 30 days after the end of
each fiscal year, shall be required to give written notice to us stating the
name and address of such owner, the number of shares of each class and series of
our stock which the owner beneficially owns and a description of the manner in
which such shares are held. Each such owner shall provide to us such additional
information as we may request in order to determine the effect, if any, of such
beneficial ownership on our status as a REIT and to ensure compliance with the
stock ownership limits. In addition, each stockholder shall upon demand be
required to provide to us such information as we may reasonably request in order
to determine our status as a REIT and to comply with the requirements of any
taxing authority or governmental authority or to determine such compliance. We
may request such information after every sale, disposition or transfer of our
common stock prior to the date a registration statement for such stock becomes
effective.
These ownership limits could delay, defer or prevent a change in control or
other transaction of us that might involve a premium price for the common stock
or otherwise be in the best interest of the stockholders.
TRANSFER AGENT AND REGISTRAR
The transfer agent and registrar for our common stock is Mellon Investor
Services LLC. Their mailing address is 85 Challenger Road, Ridgefield Park, New
Jersey 07660, Attention: Stockholder Relations. Their telephone number is (800)
356-2017.
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CERTAIN PROVISIONS OF MARYLAND LAW AND OF OUR CHARTER AND BYLAWS
The following summary highlights the material provisions of Maryland law
that are applicable to us and the material provisions of our charter and bylaws.
You should refer to Maryland law, including the MGCL, and to our charter and our
bylaws for a full description. Copies of our charter and our bylaws are filed as
exhibits to the registration statement of which this prospectus is a part. You
can also obtain copies of our charter and our bylaws and every other exhibit to
our registration statement. Please see "Where You Can Find More Information
about Luminent Mortgage Capital" on page 121 below.
CLASSIFICATION OF BOARD OF DIRECTORS
Our bylaws provide that the number of directors may be established,
increased or decreased by our board of directors but may not be fewer than the
minimum number required by the MGCL (which currently is one) nor more than 15.
Any vacancy on our board may be filled only by a majority of the remaining
directors, even if such a majority constitutes fewer than a quorum. Our bylaws
provide that a majority of our board of directors must be independent directors.
Pursuant to our charter, our board of directors is divided into three
classes of directors. Beginning in 2004, directors of each class will be chosen
for three-year terms upon the expiration of their current terms and each year
one class of our directors will be elected by our stockholders. The initial
terms of the first, second and third classes will expire in 2004, 2005 and 2006,
respectively. We believe that classification of our board of directors will help
to assure the continuity and stability of our business strategies and policies
as determined by our board of directors. Holders of shares of our common stock
will not have the right to cumulative voting in the election of directors.
Consequently, at each annual meeting of stockholders, the holders of a majority
of the shares of our common stock will be able to elect all of the successors of
the class of directors whose terms expire at that meeting.
The classified board provision could have the effect of making the
replacement of incumbent directors more time consuming and difficult. At least
two annual meetings of stockholders, instead of one, will generally be required
to effect a change in a majority of our board of directors. Thus, the classified
board provision could increase the likelihood that incumbent directors will
retain their positions. The staggered terms of directors may delay, defer or
prevent a tender offer or an attempt to change control of us, even though a
tender offer or change in control might be in the best interest of our
stockholders.
REMOVAL OF DIRECTORS
Our charter provides that a director may be removed only for cause (as
defined in our charter) and only by the affirmative vote of at least two-thirds
of the votes entitled to be cast by our stockholders generally in the election
of our directors. This provision of our charter will preclude stockholders from
removing incumbent directors except upon the existence of cause for removal and
a substantial affirmative vote. Also, our election in our bylaws to be subject
to certain provisions of Maryland law which vest in our board of directors the
exclusive right to fill vacancies on our board will prevent stockholders, even
if they are successful in removing incumbent directors, from filling the
vacancies created by such removal with their own nominees.
LIMITATION OF LIABILITY AND INDEMNIFICATION
The MGCL permits a Maryland corporation to include in its charter a
provision limiting the liability of its directors and officers to the
corporation and its stockholders for money damages except for liability
resulting from:
- actual receipt of an improper benefit or profit in money, property or
services, or
- active and deliberate dishonesty established by a final judgment as being
material to the cause of action.
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Our charter contains such a provision which eliminates such liability to
the maximum extent permitted by the MGCL.
Our charter and bylaws obligate us, to the maximum extent permitted by
Maryland law, to indemnify any person who is or was a party to, or is threatened
to be made a party to, any threatened or pending proceeding by reason of the
fact that such person is or was a director or officer of our company, or while a
director or officer of our company is or was serving, at our request, as a
director, officer, agent, partner or trustee of another corporation,
partnership, joint venture, limited liability company, trust, real estate
investment trust, employee benefit plan or other enterprise. To the maximum
extent permitted by Maryland law, the indemnification provided for in our
charter and bylaws shall include expenses (including attorney's fees),
judgments, fines and amounts paid in settlement and any such expenses may be
paid or reimbursed by us in advance of the final disposition of any such
proceeding.
The MGCL requires a corporation (unless its charter provides otherwise,
which our charter does not) to indemnify a director or officer who has been
successful, on the merits or otherwise, in the defense of any proceeding to
which he is made a party by reason of his service in that capacity. The MGCL
permits a corporation to indemnify its present and former directors and
officers, among others, against judgments, penalties, fines, settlements and
reasonable expenses actually incurred by them in connection with any proceeding
to which they may be made a party by reason of their service in those or other
capacities unless it is established that:
- the act or omission of the director or officer was material to the matter
giving rise to the proceeding and (a) was committed in bad faith or (b)
was the result of active and deliberate dishonesty;
- the director or officer actually received an improper personal benefit in
money, property or services; or
- in the case of any criminal proceeding, the director or officer had
reasonable cause to believe that the act or omission was unlawful.
However, under the MGCL, a Maryland corporation may not indemnify for an adverse
judgment in a suit by or in the right of the corporation or for a judgment of
liability on the basis that personal benefit was improperly received, unless in
either case a court orders indemnification and then only for expenses. In
addition, the MGCL permits a corporation to advance reasonable expenses to a
director or officer upon the corporation's receipt of
- a written affirmation by the director or officer of his good faith belief
that he has met the standard of conduct necessary for indemnification by
the corporation, and
- a written undertaking by or on his behalf to repay the amount paid or
reimbursed by the corporation if it shall ultimately be determined that
the standard of conduct was not met.
BUSINESS COMBINATIONS
Under the MGCL, certain "business combinations" (including a merger,
consolidation, share exchange or, in certain circumstances, an asset transfer or
certain issuances or reclassifications of equity securities) between a Maryland
corporation and any "interested stockholder" or any affiliate of an interested
stockholder are prohibited for five years after the most recent date on which a
person or entity becomes an interested stockholder. An interested stockholder is
any person or entity who beneficially owns 10% or more of the voting power of
the corporation's shares, or any affiliate of such a person or entity, or any
person or entity that was the beneficial owner of 10% or more of the voting
power of the then-outstanding voting stock of the corporation at any time within
the two-year period prior to the date in question, or any affiliate of such a
person or entity. After the five-year period has elapsed, any such business
combination must be recommended by our board of directors and approved by the
affirmative vote of at least (1) 80% of the votes entitled to be cast by holders
of outstanding shares of voting stock of the corporation and (2) two-thirds of
the votes entitled to be cast by holders of voting stock of the corporation
other than shares held by the interested stockholder with whom (or with whose
affiliate) the business combination is to be effected, unless, among other
conditions, the corporation's common
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stockholders receive a minimum price (as defined in the MGCL) for their shares
and the consideration is received in cash or in the same form as previously paid
by the interested stockholder for its shares. These provisions of the MGCL do
not apply, however, to business combinations that are approved or exempted by
our board of directors prior to the time that the interested stockholder becomes
an interested stockholder.
Our board of directors has adopted a resolution exempting the company from
the provisions of the MGCL relating to business combinations with interested
stockholders or affiliates of interested stockholders. However, such resolution
can be altered or repealed, in whole or in part, at any time by our board of
directors.
CONTROL SHARE ACQUISITIONS
The MGCL provides that "control shares" of a Maryland corporation acquired
in a "control share" acquisition have no voting rights except to the extent
approved by a vote of two-thirds of the votes entitled to be cast on the matter,
excluding shares of stock owned by the acquiror, by officers or by directors who
are employees of the corporation. "Control shares" are voting shares of stock
which, if aggregated with all other such shares of stock previously acquired by
the acquiror or in respect of which the acquiror is able to exercise or direct
the exercise of voting power (except solely by virtue of a revocable proxy),
would entitle the acquiror to exercise voting power in electing directors within
one of the following ranges of voting power:
- one-tenth or more, but less than one-third;
- one-third or more, but less than a majority; or
- a majority or more of all voting power.
Control shares do not include shares the acquiring person is then entitled
to vote as a result of having previously obtained stockholder approval. A
"control share acquisition" means the acquisition of control shares, subject to
certain exceptions.
A person who has made or proposes to make a control share acquisition, upon
satisfaction of certain conditions (including an undertaking to pay expenses),
may compel our board of directors of the corporation to call a special meeting
of stockholders to be held within 50 days of demand to consider the voting
rights of the shares. If no request for a meeting is made, the corporation may
itself present the question at any stockholders' meeting.
If voting rights are not approved at the meeting or if the acquiring person
does not deliver an acquiring person statement as required by the statute, then,
subject to certain conditions and limitations, the corporation may redeem any or
all of the control shares (except those for which voting rights have previously
been approved) for fair value determined, without regard to the absence of
voting rights for the control shares, as of the date of the last control share
acquisition by the acquiror or of any meeting of stockholders at which the
voting rights of such shares are considered and not approved. If voting rights
for control shares are approved at a stockholders' meeting and the acquiror
becomes entitled to vote a majority of the shares entitled to vote, all other
stockholders may exercise appraisal rights. The fair value of the shares as
determined for purposes of such appraisal rights may not be less than the
highest price per share paid by the acquiror in the control share acquisition.
The control share acquisition statute does not apply:
- to shares acquired in a merger, consolidation or share exchange if the
corporation is a party to the transaction; or
- to acquisitions approved or exempted by our charter or bylaws of the
corporation.
Our bylaws contain a provision exempting from the control share acquisition
statute any and all acquisitions by any person of our shares of stock. We cannot
assure you that such provision will not be amended or eliminated at any time in
the future.
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AMENDMENTS TO THE CHARTER
Except as provided below, our charter, including its provisions on
classification of our board of directors, may be amended only if approved by our
stockholders by the affirmative vote of not fewer than a majority of all of the
votes entitled to be cast on the matter. Amendments to the provisions of our
charter relating to the removal of directors will be required to be approved by
our stockholders by the affirmative vote at least two-thirds of all votes
entitled to be cast on the matter.
DISSOLUTION
Our dissolution must be approved by our stockholders by the affirmative
vote of not fewer than a majority of all of the votes entitled to be cast on the
matter.
MEETINGS OF STOCKHOLDERS; ADVANCE NOTICE OF DIRECTOR NOMINATIONS AND NEW
BUSINESS
Annual Meetings. Our annual meeting of stockholders will be held each May.
Our bylaws provide that with respect to an annual meeting of stockholders,
director nominations and stockholder proposals may be made only:
- pursuant to our notice of the meeting;
- at the direction of our board of directors; or
- by a stockholder who is entitled to vote at the meeting and has complied
with the advance notice procedures set forth in our bylaws.
For nominations or other proposals to be properly brought before an annual
meeting of stockholders by a stockholder, the stockholder must have given timely
notice in writing to our corporate secretary and any such proposal must
otherwise be a proper matter for stockholder action.
To be timely, a stockholder's notice must be delivered to our corporate
secretary at our principal executive offices not later than the close of
business on the 90th calendar day nor earlier than the close of business on the
120th calendar day prior to the first anniversary of the preceding year's annual
meeting; except that in the event that the date of the annual meeting is more
than 30 calendar days before or more than 60 calendar days after such
anniversary date, notice by the stockholder to be timely must be so delivered
not earlier than the close of business on the 120th calendar day prior to such
annual meeting and not later than the close of business on the later of the 90th
calendar day prior to such annual meeting or the 10th calendar day following the
calendar day on which we first make a public announcement of the date of such
meeting.
A stockholder's notice must set forth:
- as to each person whom the stockholder proposes to nominate for election
or reelection as a director, all information relating to such person that
is required to be disclosed in solicitation of proxies for election of
directors in an election contest, or is otherwise required, in each case
pursuant to Regulation 14A of the Exchange Act, including such person's
written consent to be named as a nominee and serving as a director if
elected;
- as to any other business that the stockholder proposes to bring before
the meeting, a brief description of the business to be brought before the
meeting, the reasons for conducting such business at the meeting, and any
material interest in such business of such stockholder and of any such
stockholder's affiliates and of any person who is the beneficial owner,
if any, of such stock; and
- as to the stockholder giving notice and each beneficial owner, if any, of
such stock, the name and address of such stockholder, as they appear on
the company's stock ownership records, and the name and address of each
beneficial owner of such stock, and the class and number of shares of
stock of the company which are owned of record or beneficially by each
such person.
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Special Meetings. Special meetings of our stockholders may be called only
by our president or by our board of directors, unless otherwise required by law.
Special meetings of our stockholders shall also be called by our secretary upon
the written request of stockholders entitled to cast at least a majority of all
votes entitled to be cast at such meeting. The date, time and place of any
special meetings will be set by our board. Our bylaws provide that with respect
to special meetings of our stockholders, only the business specified in our
notice of meeting may be brought before the meeting, and nominations of persons
for election to our board of directors may be made only:
- pursuant to our notice of the meeting;
- by or at the direction of our board of directors; or
- provided that our board of directors has determined that directors shall
be elected at such meeting, by a stockholder who is entitled to vote at
the meeting and has complied with the advance notice provisions set forth
in our bylaws.
ANTI-TAKEOVER EFFECT OF CERTAIN PROVISIONS OF MARYLAND LAW AND OF OUR CHARTER
AND BYLAWS
If the resolution of our board of directors and the applicable provisions
in our bylaws exempting us from the business combination provisions and the
control share acquisition provisions of the MGCL are rescinded, the business
combination provisions and the control share acquisition provisions of the MGCL,
the provisions of our charter on classification of our board of directors and
removal of directors and the advance notice provisions of our bylaws and certain
other provisions of our charter and bylaws and the MGCL could delay, defer or
prevent a change in control of us or other transactions that might involve a
premium price for holders of our common stock or otherwise be in their best
interest.
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COMMON STOCK AVAILABLE FOR FUTURE SALE
Prior to our IPO on December 18, 2003, there was no public market for our
stock. Our common stock began trading on the NYSE under the trading symbol "LUM"
on December 19, 2003. Future sales of substantial amounts of our common stock in
the public market, or the possibility of such sales occurring, could harm
prevailing market prices for our common stock or could impair our ability to
raise capital through further offerings of equity securities.
As of March 29, 2004, we had outstanding 24,841,146 shares of common stock
and options to purchase an additional 55,000 shares. We also have reserved an
additional 943,505 shares of our common stock for issuance upon exercise of
other options or other awards which may be granted in the future under our stock
incentive plans. Of the 24,841,146 shares outstanding on March 29, 2004, we sold
13,110,000 in our IPO, we issued 1,495 under our 2003 stock incentive plan and
an additional 11,500,000 are offered for resale pursuant to a registration
statement that was declared effective on February 13, 2004. We have agreed to
use our commercially reasonable efforts to keep the resale registration
statement effective until the date on which no "registrable shares" (as defined
in the registration rights agreement) remain outstanding, which will generally
occur when all of the privately placed shares have either been resold in a
registered sale or are eligible for resale under Rule 144. In addition, our
obligation to keep the resale registration statement effective is subject to
specified, permitted exceptions. We may suspend the selling stockholders' use of
the resale prospectus and offers and sales of the shares of our common stock
pursuant to the resale prospectus for a period not to exceed 60 days in any
90-day period, and not to exceed an aggregate of 60 days in any 12-month period
commencing on June 11, 2003, if our board makes a good faith determination that
a suspension is in our best interests. If we do not make certain filings with
the SEC in accordance with the registration rights agreement, subject to the
permitted suspension periods, we may be required to hold in a segregated,
interest-bearing account in trust for, and not to release to, Seneca the
incentive compensation otherwise payable to Seneca under the management
agreement until we have made the requisite filings.
All of the shares sold in our IPO, issued under our 2003 stock incentive
plan and/or sold pursuant to our resale registration statement will be freely
tradable without restriction under the Securities Act except for shares
purchased by our "affiliates" as that term is defined under the Securities Act.
The remaining 229,651 shares of our common stock held by our existing
stockholders are "restricted" shares as that term is defined in Rule 144 under
the Securities Act. We issued the restricted shares in private transactions in
reliance upon exemptions from the registration requirements under the Securities
Act. Restricted shares may be sold in the public market only after registration
under the Securities Act or qualification for an exemption from the registration
requirement, such as Rule 144 under the Securities Act, which is described
below.
Our directors and officers and some of our other stockholders, including
Seneca, have entered into lock-up agreements. These lock-up agreements provide
that, with limited exceptions:
- all of our directors and officers and Seneca have agreed not to offer,
sell, contract to sell, grant any option to purchase or otherwise dispose
of any of our shares until June 28, 2004, which is the 91st day after the
date of this prospectus; and
- most of our directors and officers and some of our other stockholders,
including Seneca, have agreed not to offer, sell, contract to sell, grant
any option to purchase or otherwise dispose of any of our shares until
May 14, 2004, which is the 91st day after February 13, 2004, the
effective date of our resale registration statement.
The transfer restrictions described above do not apply to shares of our common
stock purchased in the secondary market following this offering. Friedman,
Billings, Ramsey & Co., Inc. may, in its sole discretion and at any time without
prior notice, release all or any portion of the shares subject to these lock-up
agreements.
The 1,495 shares issued through March 29, 2004 as incentive bonus
compensation under our 2003 stock incentive plan are "restricted stock" as that
term is used in the plan and may not be resold until
113
they vest. Similarly the 25,651 shares issued to Seneca through March 29, 2004
as incentive compensation are subject to transfer restrictions under a
restricted stock award agreement, the form of which appears as an exhibit to the
registration statement of which this prospectus is a part. Approximately
one-third of these 27,146 restricted shares will first become available for sale
on each of first three anniversaries of the date of issuance, commencing
February 4, 2005.
Taking into account the lock-up agreements and the vesting conditions, the
number of shares that will be available for sale in the public market under Rule
144, including subsection (k), and Rule 701 under the Securities Act, will be as
follows:
DATE OF AVAILABILITY FOR SALE NUMBER OF SHARES
----------------------------- ----------------
May 14, 2004................................................ 314,079
June 28, 2004(1)............................................ 405,648
February 4, 2005............................................ 9,042
February 4, 2006............................................ 9,052
February 4, 2007............................................ 9,052
---------------
(1) Includes (a) 126,948 shares also covered by lock-up agreements entered into
by some of our directors and officers and Seneca in connection with our June
2003 private placement, and (b) 391,138 shares also covered by lock-up
agreements entered into by our directors and officers and Seneca in
connection with our IPO.
Following the expiration of the lock-up period, shares issued upon exercise
of options granted by us prior to the completion of this offering will also be
available for sale in the public market pursuant to Rule 701 under the
Securities Act unless those shares are held by one of our affiliates, directors
or officers.
In general, under Rule 144 as currently in effect, a person, or persons
whose shares are aggregated, who has beneficially owned restricted shares for at
least one year, including the holding period of any prior owner except an
affiliate, would be entitled to sell within any three-month period a number of
shares that does not exceed the greater of:
- 1% of the number of shares of our common stock then outstanding, which
equals approximately 248,411 shares as of March 29, 2004; or
- the average weekly trading volume of our common stock during the four
calendar weeks preceding the filing of a Form 144 with respect to such
sale.
Sales in accordance with Rule 144 under the Securities Act are also subject
to manner of sale provisions that require arm's length sales through a
stockbroker, notice requirements with respect to sales by our officers,
directors and greater than five percent stockholders and to the availability of
current public information about us. Under Rule 144(k), a person who is not
deemed to have been an affiliate of our company at any time during the three
months preceding a sale, and who has beneficially owned the shares proposed to
be sold for at least two years including the holding period of any prior owner
except an affiliate, is entitled to sell such shares without complying with the
manner of sale, public information, volume limitation or notice provisions of
Rule 144.
Rule 701, as currently in effect, permits our employees, officers,
directors or consultants who purchased shares under a written compensatory plan
or contract to resell these shares in reliance upon Rule 144. Rule 701 provides
that affiliates may sell their Rule 701 shares under Rule 144 without complying
with the holding period requirement and that non-affiliates may sell these
shares in reliance on Rule 144 without complying with the holding period, public
information, volume limitation or notice provisions of Rule 144.
We recently filed a registration statement on Form S-8 under the Securities
Act covering 1.0 million shares of our common stock issued or reserved for
issuance under our stock incentive plans and/or subject to outstanding options
under such plans. Shares of our common stock issued as stock grants or upon
114
exercise of options under the Form S-8 will be available for sale in the public
market, subject to Rule 144 volume limitations applicable to affiliates and
subject to the contractual restrictions described above. In addition, we have
agreed to file a shelf registration statement covering the shares of our common
stock issued to Seneca as the equity component of the incentive compensation.
We cannot assure you of:
- the likelihood that an active market for the shares will develop;
- the liquidity of any such market;
- the ability of the stockholders to sell their common stock; or
- the prices that stockholders may be able to obtain for their common
stock.
115
PRINCIPAL STOCKHOLDERS
The following table presents information known to us regarding the
beneficial ownership of our common stock. In accordance with SEC rules, each
listed person's beneficial ownership includes:
- all shares the investor actually owns (of record or beneficially);
- all shares over which the investor has or shares voting or dispositive
control (such as in the capacity as a general partner of an investment
fund); and
- all shares the investor has the right to acquire within 60 days (such as
upon exercise of options that are currently vested or which are scheduled
to vest within 60 days).
Information is given as of March 29, 2004 on an actual basis and as
adjusted to reflect the sale of our common stock in this offering. The table
presents information regarding:
- each of our named executive officers;
- each director of our company;
- all of our directors and executive officers as a group; and
- each stockholder known to us to own beneficially more than five percent
of our common stock.
Except as otherwise noted, the beneficial owners named in the following
table have sole voting and investment power with respect to all shares of our
common stock shown throughout as beneficially owned by them, subject to
community property laws, where applicable.
BENEFICIAL OWNERSHIP BENEFICIAL OWNERSHIP
BEFORE OFFERING AFTER OFFERING
---------------------- ----------------------
NUMBER PERCENT(1) NUMBER PERCENT(1)
--------- ---------- --------- ----------
FIVE PERCENT OR MORE STOCKHOLDERS
Ronald L. Eubel(2)................................ 1,744,530 7.0% 1,744,530 4.7%
Mark E. Brady(2).................................. 1,744,070 7.0% 1,744,070 4.7%
Robert J. Suttman, II(2).......................... 1,744,070 7.0% 1,744,070 4.7%
William Hazel(2).................................. 1,744,070 7.0% 1,744,070 4.7%
Bernie Holtgrieve(2).............................. 1,744,070 7.0% 1,744,070 4.7%
Eubel Brady & Suttman Asset Management, Inc.(2)... 1,716,170 6.9% 1,716,170 4.7%
DIRECTORS AND OFFICERS(3)
Gail P. Seneca, Ph.D. ............................ 107,527 * 107,527 *
Albert J. Gutierrez, CFA.......................... 115,848 * 115,848 *
Bruce A. Miller, CPA(4)........................... 1,000 * 2,000 *
John McMahan...................................... 4,200 * 4,200 *
Robert B. Goldstein............................... 37,921 * 37,921 *
Donald H. Putnam(4)............................... 15,000 * 25,000 *
Joseph E. Whitters, CPA........................... 50,000 * 50,000 *
Christopher J. Zyda(4)............................ 4,783 * 8,283 *
Andrew S. Chow, CFA............................... 32,565 * 32,565 *
Troy A. Grande, CFA............................... 32,565 * 32,565 *
--------- --- --------- ---
All directors and executive officers as a group
(10 persons)................................. 401,409 1.6% 415,909 1.1%
---------------
* Holdings represent less than 1% of all shares outstanding.
(1) Calculated using 24,841,146 shares of our common stock outstanding as of
March 29, 2004 plus, in the case of post-offering amounts, 12,000,000 shares
issued by us in this offering. Additionally, in
116
accordance with Rule 13d-3(d)(i) of the Exchange Act, in calculating the
percentage for each holder, we treated as outstanding the number of shares
of our common stock issuable upon exercise of the holder's options to
purchase common stock, if any, that are exercisable within 60 days of March
29, 2004, however we did not assume exercise of any other holder's options.
(2) Based on Schedule 13G filed on February 13, 2004 by Eubel Brady & Suttman
Asset Management, Inc. According to the Schedule 13G, (i) Mr. Eubel has
shared power to direct the vote of and dispose or to direct the disposition
of 1,744,070 shares and sole power to direct the vote of and dispose or to
direct the disposition of 460 shares, (ii) Messrs. Brady, Suttman, Hazel and
Holdgreive have shared power to direct the vote of and dispose or to direct
the disposition of 1,744,070 shares, and (iii) Eubel Brady & Suttman Asset
Management, Inc. has the shared power to direct the vote of and dispose or
to direct the disposition of 1,716,170 shares. The address of each of the
parties listed is 7777 Washington Village Drive, Suite 210, Dayton, Ohio
45459.
(3) The address of each of our officers and directors is c/o Luminent Mortgage
Capital, Inc., 909 Montgomery Street, Suite 500, San Francisco, California
94133.
(4) The change in beneficial ownership represents shares the listed persons have
informed us that they intend to purchase in this offering.
117
UNDERWRITING
The underwriters named below are acting through their representative,
Friedman, Billing, Ramsey & Co., Inc. Subject to the terms and conditions
contained in the underwriting agreement, we have agreed to sell to the
underwriters, and each underwriter has agreed to purchase from us, the number of
shares set forth opposite its name below. Under the terms and conditions of the
underwriting agreement, the underwriters are committed to purchase all the
common stock offered by this prospectus, other than the shares subject to the
over-allotment.
UNDERWRITER NUMBER OF SHARES
----------- ----------------
Friedman, Billings, Ramsey & Co., Inc. ..................... 6,600,000
Credit Suisse First Boston LLC.............................. 3,000,000
JMP Securities LLC.......................................... 1,500,000
Flagstone Securities, LLC................................... 900,000
----------
Total..................................................... 12,000,000
==========
We have granted the underwriters an option exercisable for 30 days after
the date of this prospectus to purchase up to 1,800,000 additional shares of
common stock to cover over-allotments, if any, at the public offering price less
the underwriting discounts set forth on the cover page of this prospectus. To
the extent that the underwriters exercise the option, each underwriter will be
committed, subject to certain conditions, to purchase that number of additional
shares of common stock that is proportionate to such underwriter's initial
commitment.
The following table shows the per share and total underwriting discounts
and commissions to be paid to the underwriters. The amounts are shown assuming
both no exercise and full exercise of the underwriters' option:
NO EXERCISE FULL EXERCISE
OF OPTION OF OPTION
----------- -------------
Per share.................................................. $ 0.84 $ 0.84
Total...................................................... $10,080,000 $11,592,000
The underwriters propose to offer our common stock directly to the public
at the price per share shown on the cover of this prospectus and to certain
dealers at this price less a concession not in excess of $0.50 per share. The
underwriters may allow, and the dealers may reallow, a concession not in excess
of $0.10 per share to certain dealers.
After the common stock being offered by this prospectus is released for
sale to the public, the underwriters may change the offering price and other
selling terms.
We expect to incur expenses, excluding underwriting fees, of approximately
$400,000 in connection with this offering.
We have agreed to indemnify the underwriters against certain liabilities,
including liabilities under the Securities Act, or to contribute to payments the
underwriters may be required to make in respect thereof. We have also agreed to
reimburse the underwriters for their NASD filing fee and the reasonably and
actually incurred cost of producing a blue-sky survey.
Our directors and officers and some of our other stockholders, including
Seneca, have entered into lock-up agreements. These lock-up agreements provide
that, with limited exceptions:
- all of our directors and officers and Seneca have agreed not to offer,
sell, contract to sell, grant any option to purchase or otherwise dispose
of any of our shares until June 28, 2004, which is the 91st day after the
date of this prospectus; and
118
- most of our directors and officers and some of our other stockholders,
including Seneca, have agreed not to offer, sell, contract to sell, grant
any option to purchase or otherwise dispose of any of our shares until
May 14, 2004, which is the 91st day after February 13, 2004, the
effective date of our resale registration statement.
Friedman, Billings, Ramsey & Co., Inc. may, in its sole discretion and at
any time without prior notice, release all or any portion of the shares subject
to these lock-up agreements. In considering a request to release shares from a
lock-up agreement, Friedman, Billings, Ramsey & Co., Inc. will likely consider a
number of factors, including the impact that such a release would have on this
offering and the market for our common stock and the equitable considerations
underlying the request for release.
The lock-up agreements entered into or to be entered into by our officers,
directors and stockholders, including Seneca, do not apply to shares of our
common stock purchased in the secondary market following this offering and do
not prohibit transfers of our common stock:
- as a bona fide gift or gifts, provided that the donee or donees thereof
agree to be bound in writing by the restrictions set forth in the lock-up
agreement;
- to any trust for the direct or indirect benefit of the stockholder or its
immediate family, provided that the trustee of the trust agrees to be
bound in writing by the restrictions set forth in the lock-up agreement;
- as a distribution to shareholders, partners or members of the
stockholder, provided that such shareholders, partners or members agree
to be bound in writing by the restrictions set forth in the lock-up
agreement;
- as required under any benefit plans or our charter;
- as collateral for any loan, provided that the lender agrees in writing to
be bound by the restrictions set forth herein;
- as a resale of securities acquired in the open market; or
- as required under the management agreement between Seneca and us.
In addition, we have agreed with Friedman, Billings, Ramsey & Co., Inc.
that during the period from December 18, 2003, which is the date of our IPO
prospectus, to June 11, 2004, we will not, offer, sell, contract to sell or
otherwise dispose of any shares of our common stock without the written consent
of Friedman, Billings, Ramsey & Co., Inc., except pursuant to our 2003 stock
incentive plan, our 2003 outside advisors plan or the other exceptions stated in
the underwriting agreement. Friedman, Billings, Ramsey & Co., Inc. has consented
to our offer and sale of shares of our common stock in this offering.
In connection with this public offering, the underwriters may purchase and
sell shares of our common stock in the open market. These transactions may
include short sales, stabilizing transactions and purchases to cover positions
created by short sales. Short sales involve the sale by the underwriters of a
greater number of shares than they are required to purchase in this offering.
"Covered" short sales are sales made in an amount not greater than the
underwriters' option to purchase additional shares from us in this offering. The
underwriters may close out any covered short position by either exercising their
option to purchase additional shares or purchasing shares in the open market. In
determining the source of shares to close out the covered short position, the
underwriters will consider, among other things, the price of shares available
for purchase in the open market as compared to the price at which they may
purchase shares through the over-allotment option. "Naked" short sales are any
sales in excess of such option. The underwriters must close out any naked short
position by purchasing shares in the open market. A naked short position is more
likely to be created if the underwriters are concerned that there may be
downward pressure on the price of the common stock in the open market after
pricing that could adversely affect investors who purchase in the public
offering. Stabilizing transactions consist of various bids for or purchase of
common stock made by the underwriters in the open market prior to the completion
of this offering.
119
The underwriters may also impose a penalty bid. This occurs when a
particular underwriter repays to the representatives a portion of the
underwriting discount received by it because the representatives have
repurchased shares sold by or for the account of such underwriter in stabilizing
or short covering transactions.
Purchases to cover a short position and stabilizing transactions may have
the effect of preventing or retarding a decline in the market price of our
stock, and together with the imposition of the penalty bid, may stabilize,
maintain or otherwise affect the market price of the common stock. As a result,
the price of the common stock may be higher than the price that otherwise might
exist in the open market. If these activities are commenced, they may be
discontinued at any time. These transactions may be effected on the NYSE, in the
over-the-counter market or otherwise.
A prospectus in electronic format may be made available on the Internet
sites of or through other online services maintained by one or more of the
underwriters participating in this offering, or by their affiliates. In those
cases, prospective investors may view offering terms online and, depending upon
the particular underwriter, prospective investors may be allowed to place orders
online. The underwriters may agree with us to allocate a specific number of
shares for sale to online brokerage account holders. Any such allocation for
online distributions will be made by the underwriters on the same basis as other
allocations. Other than the prospectus in electronic format, the information on
any underwriter's web site and any information contained in any other web site
maintained by an underwriter is not part of the prospectus or the registration
statement of which this prospectus forms a part, has not been approved and/or
endorsed by us or any underwriter in its capacity as underwriter and should not
be relied upon by investors.
A prospectus in electronic format may be made available on www.fbr.com, the
Internet web site maintained by Friedman, Billings, Ramsey Group, Inc., the
parent company of Friedman, Billings, Ramsey & Co., Inc. We will not effect any
sales of our common stock in this offering by electronic means or over the
Internet.
Friedman, Billings, Ramsey & Co., Inc. has performed financial advisory
services for us in the past. Friedman, Billings, Ramsey & Co., Inc. acted as
placement agent in connection with our June 2003 private placement and received
customary fees for such services plus reimbursement of expenses. Each of
Friedman, Billings, Ramsey & Co., Inc., Credit Suisse First Boston LLC, JMP
Securities LLC and Flagstone Securities, LLC acted as representatives of the
several underwriters in our IPO and received customary fees for such services
plus reimbursement. In addition, some of the underwriters may in the future
provide financial advisory services for us. For example, we have agreed to
engage Friedman, Billings, Ramsey & Co., Inc. to act as our financial advisor in
connection with any strategic transaction undertaken by us and as lead
underwriter or placement agent in connection with any capital markets financing
undertaken by us, in each case, on or prior to June 11, 2004.
Credit Suisse First Boston LLC is a counterparty to a repurchase agreement
with us, under which there was approximately $210.3 million outstanding as of
December 31, 2003.
120
LEGAL MATTERS
Certain legal matters will be passed upon for us by our counsel, O'Melveny
& Myers LLP, San Francisco, California. The validity of the shares of our common
stock to be sold in this offering and certain other matters of Maryland law will
be passed upon for us by Ballard Spahr Andrews & Ingersoll LLP, Baltimore,
Maryland. Certain legal matters relating to this offering will be passed upon
for the underwriters by Gibson, Dunn & Crutcher LLP, Los Angeles, California.
O'Melveny & Myers LLP and Gibson, Dunn & Crutcher LLP may rely on Ballard Spahr
Andrews & Ingersoll LLP as to matters of Maryland law. Peter T. Healy, Esq., a
partner of O'Melveny & Myers LLP, is our corporate secretary.
EXPERTS
The financial statements as of December 31, 2003 and for the period from
April 26, 2003 through December 31, 2003 included in this prospectus have been
audited by Deloitte & Touche LLP, independent auditors, as stated in their
report appearing herein, and are included in reliance upon the report of such
firm given upon their authority as experts in accounting and auditing.
WHERE YOU CAN FIND MORE INFORMATION ABOUT LUMINENT MORTGAGE CAPITAL
We have filed with the SEC a registration statement on Form S-11, including
exhibits and schedules filed with the registration statement of which this
prospectus is a part, under the Securities Act with respect to the shares of our
common stock to be sold in this offering. This prospectus does not contain all
of the information set forth in the registration statement and its exhibits and
schedules. For further information with respect to our company and the shares of
our common stock to be sold in this offering, reference is made to the
registration statement, including the exhibits and schedules to the registration
statement. Statements contained in this prospectus as to the contents of any
contract or other document referred to in this prospectus are not necessarily
complete and, where that contract is an exhibit to the registration statement,
each statement is qualified in all respects by reference to the exhibit to which
the reference relates. Copies of the registration statement, including the
exhibits and schedules to the registration statement, may be examined without
charge at the public reference room of the SEC, 450 Fifth Street, N.W. Room
1024, Washington, DC 20549. Information about the operation of the public
reference room may be obtained by calling the SEC at 1-800-SEC-0300. Copies of
all or a portion of the registration statement can be obtained from the public
reference room of the Securities and Exchange Commission upon payment of
prescribed fees. Our SEC filings, including our registration statement, are also
available to you for free on the SEC's website at www.sec.gov.
We are subject to the information and reporting requirements of the
Exchange Act, and pursuant thereto we file periodic reports, proxy statements
and other reports with the SEC. We also intend to distribute annual reports to
our stockholders containing audited financial information.
121
INDEX TO FINANCIAL STATEMENTS
FINANCIAL STATEMENTS OF LUMINENT MORTGAGE CAPITAL, INC.
Independent Auditors' Report................................ F-2
Balance Sheet as of December 31, 2003....................... F-3
Statement of Operations for the period from April 26, 2003
through December 31, 2003................................. F-4
Statement of Stockholders' Equity for the period from April
26, 2003 through December 31, 2003........................ F-5
Statement of Cash Flows for the period from April 26, 2003
through December 31, 2003................................. F-6
Notes to Financial Statements............................... F-7
F-1
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
Luminent Mortgage Capital, Inc.:
We have audited the accompanying balance sheet of Luminent Mortgage
Capital, Inc. (the "Company") as of December 31, 2003, and the related
statements of operations, stockholders' equity and cash flows for the period
from April 26, 2003 (inception) to December 31, 2003. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of Luminent Mortgage Capital, Inc. as of
December 31, 2003, and the results of its operations and its cash flows for the
period from April 26, 2003 (inception) to December 31, 2003 in conformity with
accounting principles generally accepted in the United States of America.
/s/ DELOITTE & TOUCHE LLP
San Francisco, California
February 27, 2004
F-2
LUMINENT MORTGAGE CAPITAL, INC.
BALANCE SHEET
DECEMBER 31,
2003
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) ------------
ASSETS:
Cash and cash equivalents................................. $ 7,219
Mortgage-backed securities available-for-sale, at fair
value.................................................. 352,123
Mortgage-backed securities available-for-sale, pledged as
collateral, at fair value.............................. 1,809,822
Interest receivable....................................... 7,345
Principal receivable...................................... 2,313
Other assets.............................................. 518
----------
Total assets................................................ $2,179,340
==========
LIABILITIES:
Repurchase agreements..................................... $1,728,973
Unsettled security purchases.............................. 156,127
Cash distribution payable................................. 5,267
Futures contracts, at fair value.......................... 157
Accrued interest expense.................................. 3,777
Insurance note payable.................................... 92
Accounts payable and accrued expenses..................... 1,363
Management fee payable, incentive fee payable and other
related party liabilities.............................. 1,088
----------
Total liabilities........................................... 1,896,844
STOCKHOLDERS' EQUITY:
Preferred stock, par value $0.001:
10,000,000 shares authorized; no shares issued and
outstanding as of December 31, 2003................. --
Common stock, par value $0.001:
100,000,000 shares authorized; 24,814,000 shares
issued and outstanding as of December 31, 2003...... 25
Additional paid-in capital................................ 317,339
Accumulated other comprehensive loss...................... (26,510)
Accumulated distributions in excess of accumulated
earnings............................................... (8,358)
----------
Total stockholders' equity.................................. 282,496
----------
Total liabilities and stockholders' equity.................. $2,179,340
==========
See notes to financial statements
F-3
LUMINENT MORTGAGE CAPITAL, INC.
STATEMENT OF OPERATIONS
FOR THE PERIOD
FROM
APRIL 26, 2003
THROUGH
DECEMBER 31,
2003
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) --------------
REVENUES:
Net interest income:
Interest income........................................... $ 22,654
Interest expense.......................................... 9,009
-----------
Net interest income.................................... 13,645
Losses on sales of mortgage-backed securities............. (7,831)
EXPENSES:
Management fee expense to related party................... 901
Incentive fee expense to related party.................... 980
Salaries and benefits..................................... 99
Professional services..................................... 477
Board of directors expense................................ 117
Insurance expense......................................... 291
Custody expense........................................... 115
Other general and administrative expenses................. 73
-----------
Total expenses.............................................. 3,053
-----------
Net income.................................................. $ 2,761
===========
Net income per share -- basic............................... $ 0.27
===========
Net income per share -- diluted............................. $ 0.27
===========
Weighted-average number of shares outstanding -- basic...... 10,139,280
===========
Weighted-average number of shares outstanding -- diluted.... 10,139,811
===========
See notes to financial statements
F-4
LUMINENT MORTGAGE CAPITAL, INC.
STATEMENT OF STOCKHOLDERS' EQUITY
ACCUMULATED
COMMON STOCK ACCUMULATED DISTRIBUTIONS
-------------- ADDITIONAL OTHER IN EXCESS OF
PAR PAID-IN COMPREHENSIVE ACCUMULATED COMPREHENSIVE
SHARES VALUE CAPITAL LOSS EARNINGS INCOME/(LOSS) TOTAL
------ ----- ---------- ------------- ------------- ------------- --------
(IN THOUSANDS)
Balance, April 26,
2003................. 204 $ 1 $ -- $ -- $ -- $ -- $ 1
Net income............. 2,761 2,761 2,761
Mortgage-backed
securities
available-for-sale,
fair value
adjustment........... (26,353) (26,353) (26,353)
Futures contracts, fair
value adjustment..... (157) (157) (157)
--------
Comprehensive loss..... $(23,749)
========
Distributions to
stockholders......... (11,119) (11,119)
Issuance of common
stock................ 24,610 24 316,723 316,747
Capital contribution... 613 613
Amortization of stock
options.............. 3 3
------ --- -------- -------- -------- --------
Balance, December 31,
2003................. 24,814 $25 $317,339 $(26,510) $ (8,358) $282,496
====== === ======== ======== ======== ========
See notes to financial statements
F-5
LUMINENT MORTGAGE CAPITAL, INC.
STATEMENT OF CASH FLOWS
FOR THE PERIOD
FROM
APRIL 26, 2003
THROUGH
DECEMBER 31,
2003
--------------
(IN THOUSANDS)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................ $ 2,761
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization of premium/discount on mortgage-backed
securities available-for-sale.......................... 9,189
Amortization of stock options............................. 3
Losses on sales of mortgage-backed securities............. 7,831
Incentive fee waived by related party..................... 613
Changes in operating assets and liabilities:
Increase in interest receivable, net of purchased
interest.............................................. (116)
Increase in other assets............................... (518)
Increase in accounts payable and accrued expenses...... 1,363
Increase in interest payable........................... 3,777
Increase in management fee payable, incentive fee
payable and other related party liabilities........... 1,088
-----------
Net cash provided by operating activities............ 25,991
-----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage-backed securities
available-for-sale..................................... (2,797,073)
Proceeds from sales of mortgage-backed securities......... 538,780
Principal payments of mortgage-backed securities.......... 199,560
-----------
Net cash used in investing activities................ (2,058,733)
-----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of common stock................ 316,747
Borrowings under repurchase agreements.................... 10,097,957
Principal payments on repurchase agreements............... (8,368,984)
Payment of cash distributions............................. (5,852)
Borrowings under margin loan.............................. 4,266
Paydown of margin loan.................................... (4,266)
Borrowings under note payable, net........................ 92
-----------
Net cash provided by financing activities............ 2,039,960
-----------
NET INCREASE IN CASH AND CASH EQUIVALENTS................... 7,218
CASH AND CASH EQUIVALENTS, BEGINNING OF THE PERIOD.......... 1
-----------
CASH AND CASH EQUIVALENTS, END OF THE PERIOD................ $ 7,219
===========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid............................................. $ 5,222
NON-CASH INVESTING ACTIVITY:
Increase in unsettled security purchases.................. $ 156,127
Increase in principal receivable.......................... (2,313)
See notes to financial statements
F-6
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS
NOTE 1 -- ORGANIZATION
Luminent Mortgage Capital, Inc., or the Company, was organized as a
Maryland corporation on April 25, 2003. The Company commenced its operations of
purchasing and holding an investment portfolio of mortgage-backed securities on
June 11, 2003, upon completion of a private placement offering. On December 18,
2003, the Company completed the initial public offering of its shares of common
stock and began trading on the New York Stock Exchange under the trading symbol
LUM on December 19, 2003.
Seneca Capital Management LLC, or the Manager, pursuant to a management
agreement, or the Management Agreement, manages the Company and its investment
portfolio. See Note 7 for further discussion on the Management Agreement.
The Company intends to elect to be taxed as a Real Estate Investment Trust,
or REIT, and to comply with the provisions of the Internal Revenue Code, or the
Code, with respect thereto. See Note 2 for further discussion on income taxes.
NOTE 2 -- ACCOUNTING POLICIES
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand and highly liquid
investments with maturities of three months or less at the time of purchase. The
carrying amount of cash equivalents approximates their fair value. The Company's
primary bank account is a sweep account with the custodian bank.
SECURITIES
The Company invests primarily in U.S. agency and other highly-rated,
single-family, adjustable-rate, hybrid adjustable-rate and fixed-rate
mortgage-backed securities issued in the United States market.
The Company classifies its investments as either trading,
available-for-sale or held-to-maturity securities. Management determines the
appropriate classification of the securities at the time they are acquired and
evaluates the appropriateness of such classifications at each balance sheet
date. The Company currently classifies all of its securities as
available-for-sale. All assets that are classified as available-for-sale are
carried at fair value and unrealized gains or losses are included in accumulated
other comprehensive loss as a component of stockholders' equity. The fair values
of mortgage-backed securities are determined by management based upon price
estimates provided by independent pricing services and securities dealers. In
the event that a security becomes impaired (e.g., if the fair value falls below
the amortized cost basis and recovery is not expected before the security is
sold), the cost of the security would be written down and the difference would
be reflected in current earnings. The determination of other-than-temporary
impairment is evaluated at least quarterly.
Interest income is accrued based upon the outstanding principal amount of
the securities and their contractual terms. Premiums and discounts are amortized
or accreted into interest income over the lives of the securities using the
effective yield method adjusted for the effects of estimated prepayments based
on Statement of Financial Accounting Standards, or SFAS, No. 91, Accounting for
Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases.
Security transactions are recorded on the trade date. Realized gains and
losses from security transactions are determined based upon the specific
identification method.
DERIVATIVE FINANCIAL INSTRUMENTS
The Company may enter into derivative contracts, including futures
contracts and interest rate swaps, as a means of mitigating the Company's
interest rate risk on forecasted interest expense associated with
F-7
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
the benchmark rate on forecasted rollover/reissuance of repurchase agreements,
or hedged items, for a specified future time period. The Company has designated
these transactions as cash flow hedges. The contracts, or hedge instruments, are
evaluated at inception and on an ongoing basis in order to determine whether
they qualify for hedge accounting under SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, as amended and interpreted. The hedge
instrument must be highly effective in achieving offsetting changes in the
hedged item attributable to the risk being hedged in order to qualify for hedge
accounting. Derivative contracts are carried on the balance sheet at fair value.
Any ineffectiveness which arises during the hedging relationship, is recognized
in interest expense during the period in which it arises. Prior to the end of
the specified hedge time period the effective portion of all contract gains and
losses (whether realized or unrealized) is recorded in other comprehensive
income or loss. Realized gains and losses are reclassified into earnings as an
adjustment to interest expense during the specified hedge time period.
REPURCHASE AGREEMENTS
The Company finances the acquisition of its securities primarily through
the use of repurchase agreements. Repurchase agreements are treated as
collateralized financing transactions and are carried at their contractual
amounts, including accrued interest, as specified in the respective agreements.
Accrued interest on repurchase agreements is recorded as a separate line item on
the balance sheet.
INCOME TAXES
The Company intends to elect to be taxed as a REIT and to comply with the
provisions of the Code with respect thereto. Accordingly, the Company is not
subject to Federal or state income tax to the extent that its distributions to
stockholders satisfy the REIT requirements and certain asset, income and stock
ownership tests are met.
Distributions declared per share were $0.95 for the period from April 26,
2003 through December 31, 2003. All distributions were classified as ordinary
income to stockholders for income tax purposes.
STOCK COMPENSATION
As of December 31, 2003, the Company had 55,000 outstanding stock options,
and intends to issue stock options in the future. Such options may be issued to
Company employees and directors, and to employees of the Manager. The Company
accounts for stock options issued to its own employees and directors using the
fair value based methodology prescribed by SFAS No. 123, Accounting for
Stock-Based Compensation. Stock options issued to employees of the Manager will
be recognized as expense over the vesting period based on their fair value.
INCENTIVE COMPENSATION
The Company has a Management Agreement that provides for the payment of an
incentive fee to the Manager if the Company's financial performance exceeds
certain benchmarks. See Note 7 for further discussion on the specific terms of
the computation and payment of the incentive fee.
The cash portion of the incentive fee is accrued and expensed during the
period for which it is calculated and earned. The Company accounts for the
restricted stock portion of the incentive fee in accordance with SFAS No. 123,
and related interpretations, and Emerging Issues Task Force, or EITF, 96-18,
Accounting for Equity Instruments That Are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services.
In accordance with the consensus on Issue 1 in EITF 96-18, the measurement
date of the shares issued for incentive compensation is the date when the
Manager's performance is complete. Since
F-8
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
continuing service is required in order for the restrictions on issued shares to
lapse and for ownership to vest, for each one-third tranche (based on varying
restriction/vesting periods) of shares issued for a given period, performance is
considered to be complete when the restriction period for that tranche ends and
ownership vests. The period over which the stock is earned by the Manager (i.e.,
the period during which services are provided before the stock vests) is both
the period during which the incentive compensation was initially calculated and
the vesting period for each tranche issued. Therefore, expense for the stock
portion of incentive fees issued for a given period is spread over five quarters
for the first tranche (shares vesting one year after issuance), nine quarters
for the second tranche (shares vesting two years after issuance), and 13
quarters for the third tranche. In accordance with the consensus on Issue 2 in
EITF 96-18, the fair value of the shares issued is recognized in the same manner
as if the Company had paid cash to the Manager for its services. When the shares
are issued, they are recorded at the then-current fair value in stockholders'
equity, with an offsetting entry to deferred compensation (a contra-equity
account). The deferred compensation account is reduced and expense is recognized
quarterly up to the measurement date, as discussed above. In accordance with the
consensus in Issue 3 of EITF 96-18, fair value is adjusted quarterly for
unvested shares, and changes in such fair value each quarter are reflected in
the expense recognized in that quarter and in future quarters. By the end of the
quarter in which performance is complete (i.e., the measurement date), the
deferred compensation account is reduced to zero and there are no further
adjustments to equity for changes in fair value of the shares.
The Company also pays an incentive fee, in the form of cash and restricted
stock, to the Company's Chief Financial Officer, in accordance with the terms of
his employment agreement. The incentive fee is accounted for in the same manner
as the incentive fee earned by the Manager.
NET INCOME PER SHARE
The Company calculates basic earnings per share by dividing net income for
the period by weighted-average shares of its common stock outstanding for that
period. Diluted earnings per share takes into account the effect of dilutive
instruments, such as stock options, but uses the average share price for the
period in determining the number of incremental shares that are to be added to
the weighted-average number of shares outstanding.
USE OF ESTIMATES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates. Estimates affecting the accompanying financial statements include the
fair values of mortgage-backed securities and the prepayment speeds used to
calculate amortization and accretion of premiums and discounts on
mortgage-backed securities.
CONCENTRATIONS OF CREDIT RISK AND OTHER RISKS AND UNCERTAINTIES
The Company's investments are concentrated in securities that pass through
collections of principal and interest from underlying mortgages, and there is a
risk that some borrowers on the underlying mortgages will default. Therefore,
mortgage-backed securities may bear some exposure to credit losses. However, the
Company mitigates credit risk by holding securities that are either guaranteed
by government or government-sponsored agencies or have credit ratings of AAA or
higher. As of December 31, 2003, 63% of the Company's mortgage-backed securities
portfolio, as measured by its fair value, was agency-guaranteed.
F-9
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
The Company bears certain other risks typical in investing in a portfolio
of mortgage-backed securities. Principal risks potentially affecting the
Company's financial position, results of operations and cash flows include the
risks that: (a) interest rate changes can negatively affect the market value of
the Company's mortgage-backed securities, (b) interest rate changes can
influence decisions made by borrowers on the mortgages underlying the securities
to prepay those mortgages, which can negatively affect both cash flows from, and
the market value of, the securities, and (c) adverse changes in the market value
of the Company's mortgage-backed securities and/or the inability of the Company
to renew short-term borrowings can result in the need to sell securities at
inopportune times and incur realized losses.
RECENT ACCOUNTING PRONOUNCEMENTS
As of December 31, 2003, the Company has adopted early all relevant
accounting standards that have been issued by authoritative bodies in the United
States and for which adoption is not yet required. Therefore, the Company does
not anticipate that comparability of its financial statements for future periods
to the financial statements for the historical periods presented herein will be
affected by any recently-issued accounting pronouncements.
In April 2003, the Financial Accounting Standards Board, or FASB, issued
SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities. This Statement amends and clarifies financial accounting and
reporting for derivative instruments, including certain derivative instruments
embedded in other contracts and for hedging activities under SFAS No. 133. The
changes in this Statement improve financial reporting by requiring that
contracts with comparable characteristics be accounted for similarly. SFAS No.
149 was effective for contracts entered into or modified after June 30, 2003,
except as stated below, and for hedging relationships designated after June 30,
2003. All provisions of SFAS No. 149 should be applied prospectively, except for
as prescribed by the Statement. In addition, the provisions of SFAS No. 149 that
relate to forward purchases or sales of when-issued securities or other
securities that do not yet exist should be applied to both existing contracts
and new contracts entered into after June 30, 2003. Adoption of this Statement
did not have a material impact on the Company's financial position or results of
operations.
In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity. The Statement
establishes standards for how the Company should classify and measure certain
financial instruments with characteristics of both liabilities and equity. SFAS
No. 150 is effective for financial instruments entered into or modified after
May 31, 2003, and was otherwise generally effective at the beginning of the
first interim period beginning after June 15, 2003. Adoption of this Statement
did not have a material impact on the Company's financial position or results of
operations.
In December 2003, the FASB issued Interpretation, or FIN 46R, Consolidation
of Variable Interest Entities. The purpose of this interpretation is to provide
guidance on how to identify a variable interest entity, or VIE, and determine
when the assets, liabilities, noncontrolling interests, and results of
operations of a VIE need to be included in a company's consolidated financial
statements. A company that holds variable interests in an entity will need to
consolidate that entity if the company's interest in the VIE is such that the
company will absorb a majority of the VIE's expected losses and/or receive a
majority of the VIE's expected residual returns. New disclosure requirements are
also prescribed by FIN 46R. Adoption of this Statement did not have a material
impact on the Company's financial position or results of operations.
F-10
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 3 -- MORTGAGE-BACKED SECURITIES
The following table summarizes the Company's mortgage-backed securities
classified as available-for-sale as of December 31, 2003, which are carried at
fair value:
HYBRID BALLOON
ADJUSTABLE-RATE ADJUSTABLE-RATE MATURITY TOTAL MORTGAGE-
SECURITIES SECURITIES SECURITIES BACKED SECURITIES
--------------- --------------- ---------- -----------------
(IN THOUSANDS)
Amortized cost.................. $187,769 $1,944,707 $55,822 $2,188,298
Unrealized gains................ 7 1,061 -- 1,068
Unrealized losses............... (2,463) (23,828) (1,130) (27,421)
-------- ---------- ------- ----------
Fair value...................... $185,313 $1,921,940 $54,692 $2,161,945
======== ========== ======= ==========
% of total...................... 8.6% 88.9% 2.5% 100.0%
Actual maturities of mortgage-backed securities are generally shorter than
stated contractual maturities. Actual maturities of the Company's
mortgage-backed securities are affected by the contractual lives of the
underlying mortgages, periodic payments of principal, and prepayments of
principal. The following table summarizes the Company's mortgage-backed
securities on December 31, 2003 according to their estimated weighted-average
life classifications:
WEIGHTED-
AMORTIZED AVERAGE
WEIGHTED-AVERAGE LIFE FAIR VALUE COST COUPON
--------------------- -------------- -------------- ---------
(IN THOUSANDS) (IN THOUSANDS)
Less than one year.............................. $ 299,685 $ 304,556 4.07%
Greater than one year and less than five
years......................................... 1,829,471 1,850,899 4.09
Greater than five years......................... 32,789 32,843 3.96
-------------- --------------
Total........................................... $2,161,945 $2,188,298 4.09%
============== ==============
The weighted-average lives of the mortgage-backed securities at December
31, 2003 in the table above are based upon data provided through
subscription-based financial information services, assuming constant principal
prepayment rates to the balloon or reset date for each security. The prepayment
model considers current yield, forward yield, steepness of the yield curve,
current mortgage rates, mortgage rate of the outstanding loan, loan age, margin
and volatility.
The actual weighted-average lives of the mortgage-backed securities in the
Company's investment portfolio could be longer or shorter than the estimates in
the table above depending on the actual prepayment rates experienced over the
lives of the applicable securities and are sensitive to changes in both
prepayment rates and interest rates.
During the period from April 26, 3003 through December 31, 2003, the
Company sold securities totaling $130.7 million and realized a loss of $2.3
million. The Company also sold short $200 million of "to be announced" mortgage
securities. The Company closed out this short position for a total realized loss
of $5.7 million. The Company also simultaneously sold and purchased securities
totaling $215.9 million and $215.7 million, respectively, that resulted in a
realized gain on sale of $0.2 million.
At December 31, 2003, unsettled security purchases totaled $156.1 million.
These purchases settled in January 2004.
F-11
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
The following table shows the Company's investments' fair value and gross
unrealized losses, aggregated by investment category and length of time that
individual securities have been in a continuous unrealized loss position, at
December 31, 2003:
LESS THAN 12 MONTHS 12 MONTHS OR MORE TOTAL
----------------------- ------------------ -----------------------
GROSS GROSS GROSS
FAIR UNREALIZED FAIR UNREALIZED FAIR UNREALIZED
VALUE LOSSES VALUE LOSSES VALUE LOSSES
---------- ---------- ----- ---------- ---------- ----------
(IN THOUSANDS)
Agency-backed mortgage-backed
securities.................. $1,109,858 $(17,261) $ -- $ -- $1,109,858 $(17,261)
Non-agency-backed mortgage-
backed securities........... 644,448 (10,160) -- -- 644,448 (10,160)
---------- -------- ----- ----- ---------- --------
Total temporarily impaired
securities.................. $1,754,306 $(27,421) $ -- $ -- $1,754,306 $(27,421)
========== ======== ===== ===== ========== ========
At December 31, 2003, the Company was only invested in AAA-rated
non-agency-backed or agency-backed mortgage-backed securities. The temporary
impairment of the available-for-sale securities results from the fair value of
the securities falling below the amortized cost basis. As of December 31, 2003,
none of the securities held had been downgraded by a credit rating agency since
their purchase. Management intends to hold the securities until maturity,
allowing for the anticipated recovery in fair value of the securities held. As
such, management does not believe any of securities held are
other-than-temporarily impaired at December 31, 2003.
NOTE 4 -- REPURCHASE AGREEMENTS AND OTHER BORROWINGS
The Company has entered into repurchase agreements with third party
financial institutions to finance most of its mortgage-backed securities. The
repurchase agreements are short-term borrowings that bear interest rates that
have historically moved in close relationship to the three-month London
Interbank Offered Rate, or LIBOR. At December 31, 2003, the Company had an
outstanding amount of $1.7 billion with weighted-average borrowing rates of
1.19%. At December 31, 2003 securities pledged as collateral for repurchase
agreements had estimated fair values of $1.8 billion.
F-12
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 2003, the repurchase agreements had remaining maturities as
summarized below:
OVERNIGHT BETWEEN BETWEEN
(1 DAY OR 2 AND 30 31 AND 90 GREATER THAN
LESS) DAYS DAYS 90 DAYS TOTAL
--------- -------- --------- ------------ ----------
(IN THOUSANDS)
AGENCY-BACKED MORTGAGE-BACKED
SECURITIES:
Amortized cost of securities sold,
including accrued interest....... $ -- $ 14,299 $302,538 $1,010,586 $1,327,423
Fair market value of securities
sold, including accrued
interest......................... -- 14,065 302,272 994,545 1,310,882
Repurchase agreement liabilities
associated with these
securities....................... -- 12,865 281,870 952,532 1,247,267
Average interest rate of repurchase
agreement liabilities............ 0.00% 1.20% 1.11% 1.19% 1.17%
NON-AGENCY-BACKED MORTGAGE-BACKED
SECURITIES:
Amortized cost of securities sold,
including accrued interest....... $18,475 $329,592 $ -- $ 165,608 $ 513,675
Fair market value of securities
sold, including accrued
interest......................... 18,431 324,769 -- 161,881 505,081
Repurchase agreement liabilities
associated with these
securities....................... 17,490 306,911 -- 157,305 481,706
Average interest rate of repurchase
agreement liabilities............ 1.20% 1.21% 0.00% 1.29% 1.23%
TOTAL:
Amortized cost of securities sold,
including accrued interest....... $18,475 $343,891 $302,538 $1,176,194 $1,841,098
Fair market value of securities
sold, including accrued
interest......................... 18,431 338,834 302,272 1,156,426 1,815,963
Repurchase agreement liabilities
associated with these
securities....................... 17,490 319,776 281,870 1,109,837 1,728,973
Average interest rate of repurchase
agreement liabilities............ 1.20% 1.21% 1.11% 1.20% 1.19%
F-13
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 2003, the repurchase agreements had the following
counterparties, amounts at risk and weighted-average remaining maturities:
WEIGHTED-AVERAGE
MATURITY OF
REPURCHASE
AMOUNT AT AGREEMENTS IN
REPURCHASE AGREEMENT COUNTERPARTIES RISK(1) DAYS
----------------------------------- -------------- ----------------
(IN THOUSANDS)
Bear Stearns & Co. ..................................... $ 8,423 138
Banc of America Securities LLC.......................... 9,762 26
Countrywide Securities Corporation...................... 2,358 23
Credit Suisse First Boston LLC.......................... 14,350 130
Deutsche Bank Securities Inc. .......................... 2,350 146
Federal Home Loan Mortgage Corporation.................. (279) 61
Goldman Sachs & Co. .................................... (390) 58
J.P. Morgan Securities Inc. ............................ 1,649 177
Merrill Lynch Government Securities Inc./Merrill Lynch
Pierce, Fenner & Smith Inc. .......................... 6,352 189
Morgan Stanley & Co. Inc. .............................. 972 61
Salomon Smith Barney.................................... 20,287 163
UBS Securities LLC...................................... 17,379 189
--------------
Total................................................... $83,213 145
==============
---------------
(1) Equal to the fair value of securities sold, plus accrued interest income,
minus repurchase agreement liabilities, plus accrued interest expense.
The Company had a note payable of $92 thousand at December 31, 2003 for the
purpose of financing its annual directors' and officers' insurance premium at an
interest rate of 6.5%.
The Company has a margin lending facility with its primary custodian where
it may borrow money in connection with the purchase or sale of securities. The
terms of the borrowings, including the rate of interest payable, are agreed to
with the custodian for each amount borrowed. Borrowings are repayable
immediately upon demand of the custodian. At December 31, 2003, there were no
outstanding borrowings under the margin lending facility.
NOTE 5 -- CAPITAL STOCK AND EARNINGS PER SHARE
The Company had 100,000,000 shares of par value $0.001 common stock
authorized and 24,814,000 shares outstanding as of December 31, 2003. The
Company had 10,000,000 shares of par value $0.001 preferred stock authorized and
none outstanding as of December 31, 2003.
In two closings on June 11 and June 19, 2003, the Company completed a
private offering of 11,092,473 shares of common stock, $0.001 par value at an
offering price of $15.00 per share, including the exercise by the initial
purchaser/placement agent of its over-allotment option to purchase 1,500,000
shares of common stock. In addition, on June 11, 2003 the Company issued 407,527
shares of common stock, par value $0.001, at an offering price net of the
initial purchaser's discount of $13.95 per share, to employees and affiliates of
the Manager, and other persons selected by the Manager. The Company received
proceeds from these transactions in the amount of $159.7 million, net of
underwriting discount and other offering costs.
F-14
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
On December 18, 2003, the Company completed an initial public offering of
13,110,000 shares common stock, $0.001 par value at an offering price of $13.00
per share, including the exercise by the underwriter of its over-allotment
option to purchase 1,710,000 shares of common stock. The Company received
proceeds from the initial public offering in the amount of $157.0 million, net
of underwriting discount and other offering costs.
The Company filed a resale shelf registration statement with the SEC with
respect to up to 11,500,000 shares of its common stock issued in the June 11,
2003 and June 19, 2003 private offerings. The registration statement was
declared effective by the SEC on February 13, 2004.
The following table presents a reconciliation of basic and diluted earnings
per share for the period from April 26, 2003 through December 31, 2003:
BASIC DILUTED
----------- -----------
Net income (in thousands).................................. $ 2,761 $ 2,761
Weighted-average number of common shares outstanding....... 10,139,280 10,139,280
Additional shares due to:
Assumed conversion of dilutive stock options............. -- 531
----------- -----------
Adjusted weighted-average number of common shares
outstanding.............................................. 10,139,280 10,139,811
=========== ===========
Net income per share....................................... $ 0.27 $ 0.27
=========== ===========
NOTE 6 -- 2003 STOCK INCENTIVE PLANS
The Company adopted a 2003 Stock Incentive Plan, effective June 4, 2003,
and a 2003 Outside Advisors Stock Incentive Plan, effective June 4, 2003,
pursuant to which up to 1,000,000 shares of the Company's common stock is
authorized to be awarded at the discretion of the Compensation Committee of the
Board of Directors. The plans provide for the grant of a variety of long-term
incentive awards to employees and officers of the Company, individual
consultants or advisors who render or have rendered bona fide services, and
officers, employees or directors of the Manager as an additional means to
attract, motivate, retain and reward eligible persons. These plans provide for
the grant of awards that meet the requirements of Section 422 of the Code,
non-qualified stock options, stock appreciation rights, restricted stock, stock
units and other stock-based awards, and dividend equivalent rights. The maximum
term of each grant is determined on the grant date by the Compensation Committee
and shall not exceed 10 years. The exercise price and the vesting requirement of
each grant is determined on the grant date by the Compensation Committee.
The following table illustrates the stock options available for grant as of
December 31, 2003:
2003 OUTSIDE
2003 STOCK ADVISORS STOCK
INCENTIVE PLAN INCENTIVE PLAN TOTAL
-------------- -------------- ---------
Shares reserved for issuance.................... n/a(1) n/a(1) 1,000,000(1)
Granted......................................... 55,000 -- 55,000
Forfeited....................................... -- -- --
Expired......................................... -- -- --
------ --- ---------
Total available for grant....................... n/a(2) n/a(2) 945,000(2)
====== === =========
---------------
(1) At June 4, 2003, adoption date of both stock incentive plans, the maximum
number of shares of common stock that may be delivered pursuant to awards
granted under these combined plans is 1,000,000 shares.
(2) At December 31, 2003, the maximum number of shares of common stock that may
be delivered pursuant to awards granted under these combined plans is
945,000 shares.
F-15
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
At December 31, 2003, the Company had outstanding options under the plans
with expiration dates of 2013, as illustrated in the following table:
WEIGHTED-
NUMBER OF AVERAGE
OPTIONS EXERCISE PRICE
--------- --------------
Outstanding at April 26, 2003............................... -- --
Granted..................................................... 55,000 $14.82
Exercised................................................... -- --
Forfeited................................................... -- --
------ ------
Outstanding at December 31, 2003............................ 55,000 $14.82
====== ======
The following table illustrates information about stock options outstanding
at December 31, 2003:
OUTSTANDING EXERCISABLE
-------------------------------------- --------------------------
WEIGHTED-
AVERAGE
RANGE OF REMAINING WEIGHTED- WEIGHTED-
EXERCISE NUMBER OF LIFE (IN AVERAGE NUMBER OF AVERAGE
PRICES OPTIONS YEARS) EXERCISE PRICE OPTIONS EXERCISE PRICE
-------- --------- --------- -------------- --------- --------------
$13.00-$14.00.. 5,000 9.8 $13.00 -- $ --
$14.01-$15.00.. 50,000 9.6 $15.00 -- $ --
------ ----
$13.00-$15.00.. 55,000 --
====== ====
The weighted-average grant-date fair value of options granted during the
period April 26, 2003 through December 31, 2003 was $11 thousand.
The fair value of the options granted was estimated on the date of the
grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions: risk-free rate of 4.3 percent; dividend yield of
13.2 percent; expected life of 10 years; and volatility of 21.0 percent.
Total stock-based employee compensation expense for the period from April
26, 2003 through December 31, 2003 was $3 thousand.
NOTE 7 -- THE MANAGEMENT AGREEMENT
The Company has entered into a Management Agreement with the Manager that
provides, among other things, that the Company will pay to the Manager, in
exchange for investment management and certain administrative services, certain
fees and reimbursements, summarized as follows:
- a base management fee equal to a percentage of average net worth during
each fiscal year as defined in the Management Agreement (1% of the first
$300 million plus 0.8% of the amount in excess of $300 million);
- incentive compensation based on the excess of a "tiered percentage" (as
defined in the Management Agreement as the weighted-average of the
following rates based upon average net invested assets: (1) 20% for the
first $400 million of average net invested assets; and (2) 10% for the
average net invested assets in excess of $400 million) of the difference
between the Company's net income (defined in the Management Agreement as
taxable income before incentive compensation, net operating losses from
prior periods, and items permitted by the Internal Revenue Code when
calculating taxable income for a REIT) and the "threshold return" (the
amount of net income for the period that would produce an annualized
return on equity, calculated by dividing the net income, as defined in
the Management Agreement, by the average net invested assets, as defined
in the Management Agreement, equal to the 10-year U.S. Treasury rate for
the period plus 2.0%) for the fiscal period; and
- out-of-pocket expenses and certain other costs incurred by the Manager
and related directly to the Company.
F-16
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
The base management fee and incentive compensation will be paid quarterly
and are subject to adjustment at the end of each fiscal year based on annual
results. One-half of the incentive compensation will be paid to the Manager in
cash and one-half will be paid in the form of a restricted stock award under the
Company's 2003 Outside Advisors Stock Incentive Plan. The number of shares
issued is based on (a) one-half of the total incentive compensation for the
period, divided by (b) the average of the closing prices of the common stock
over the 30 day period ending three days prior to the grant date, less a fair
market value discount determined by the Company's Board of Directors. These
shares are "restricted shares" for varying periods of time, and are forfeitable
if the Manager ceases to perform management services for the Company before the
end of the restriction periods. The Company's restrictions lapse and full rights
of ownership vest for one-third of the shares on the first anniversary of the
end of the period in which the incentive compensation is calculated, for
one-third of the shares on the second anniversary and for the last one-third of
the shares on the third anniversary. Vesting is predicated on the continuing
involvement of the Manager in providing services to the Company.
From and after June 11, 2004, the Company is entitled to terminate the
Management Agreement without cause provided that the Company gives the Manager
60 days' prior written notice and pays a termination fee and other unpaid costs
and expenses reimbursable to the Manager. If the Company's terminates the
Management Agreement without cause, the Company is required to pay the Manager a
termination fee as follows:
- If the Company terminates the Management Agreement without cause in
connection with a decision to manage its portfolio internally, rather
than by an external manager, the amount of the termination fee shall be
equal to the amount of the highest annual base fee and the highest annual
incentive compensation, for a particular year, earned by the Manager
during any of the three years (or on an annualized basis if a lesser
period) preceding the effective date of the termination, plus accelerated
vesting on the equity component of all incentive compensation.
- If the Company terminates the Management Agreement without cause for any
other reason, the amount of the termination fee shall be equal to two
times the amount of the highest annual base fee and the highest annual
incentive compensation, for a particular year, earned by the Manager
during any of the three years (or on an annualized basis if a lesser
period) preceding the effective date of the termination, plus all
deferred payments, including accelerated vesting on the equity component
of all incentive compensation.
The Company is also entitled to terminate the Management Agreement with
cause, in which case the Company is only obligated to reimburse unpaid costs and
expenses.
The Management Agreement contains certain provisions requiring the Company
to indemnify the Manager for costs (e.g., legal costs) the Manager could
potentially incur in fulfilling its duties prescribed in the agreement or in
other agreements related to the Company's activities. The indemnification
provisions do not apply under all circumstances (e.g., if the Manager is grossly
negligent, acted with reckless disregard or engaged in willful misconduct or
active fraud). The provisions contain no limitation on maximum future payments.
The Company has evaluated the impact of these guarantees on its financial
statements and determined that it is immaterial.
The base management fee for the period from April 26, 2003 through December
31, 2003 was $901 thousand.
Incentive compensation is earned by the Manager when REIT taxable net
income (before deducting incentive compensation, net operating losses and
certain other items) relative to the average net invested assets for the period,
as defined in the Management Agreement, exceeds the "threshold return" taxable
income that would have produced an annualized return on equity equal to the sum
of the 10-year U.S. Treasury rate plus 2.0% for the same period. REIT taxable
net income (before deducting incentive
F-17
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
compensation, net operating losses and certain other items) for the period from
April 26, 2003 through December 31, 2003 was $11.7 million and was greater than
the "threshold return" taxable income of $5.6 million for the same period.
Incentive compensation earned by the Manager during the period from April 26,
2003 through December 31, 2003 was $1.2 million, of which $613 thousand was
waived by the Manager for the quarter ended September 30, 2003. Incentive
compensation is paid by the Company one-half in cash and one-half in restricted
stock.
Because of the timing of the Company's initial investment of portfolio
assets (investment activities began on June 11, 2003, the first security
purchase settled on June 16, 2003, and $407.8 million of securities had yet to
settle as of June 30, 2003), interest income for the period from April 26, 2003
through June 30, 2003 was substantially lower than would be expected for a
typical full period, both in an absolute sense and also relative to the average
net invested assets for the period. However, for incentive compensation purposes
the calculation for "threshold return" net income is based on average net
invested assets for the period with no adjustments made to account for such
timing differences. As a result, REIT taxable net income (before deducting
incentive compensation, net operating losses and certain other items), for the
period from April 26, 2003 through June 30, 2003, was $298 thousand and was less
than the "threshold return" net income of $426 thousand and, therefore, no
incentive fee was earned by the Manager or paid by the Company for that period.
The Company did not pay incentive compensation to the Manager for the
quarter ended September 30, 2003. Although the Manager was entitled to receive
incentive compensation under the Management Agreement for the quarter ended
September 30, 2003, because of the net loss reported by the Company for the
period, the Manager voluntarily waived, on a one-time basis, its right to
incentive compensation for the period due to the net loss reported during that
same period. Since the Manager waived its right to its incentive compensation
for the period ended September 30, 2003, the waived incentive fee of $613
thousand was expensed and accounted for as a capital contribution as of
September 30, 2003.
For the quarter ended December 31, 2003, total incentive fees for the
Manager were $606 thousand, one-half payable in cash and one-half payable in the
form of the Company's common stock as described above. The cash portion of the
incentive fee of $303 thousand for the quarter ended December 31, 2003 was
expensed in that period. In accordance with SFAS No. 123, and related
interpretations, and EITF 96-18, 15.2% of the restricted stock portion of the
incentive fees, or $46 thousand, was expensed in the quarter ended December 31,
2003. Included in other assets at December 31, 2003 is $257 thousand of deferred
compensation which will be reclassified to stockholders' equity after the
restricted stock is issued and will be expensed over the three-year vesting
period of the restricted stock.
The remaining incentive fee for the quarter ended December 31, 2003 of $30
thousand was earned by the Company's Chief Financial Officer, in accordance with
the terms of his employment agreement. This portion of the incentive fee is also
payable one-half in cash and one-half in the form of a restricted stock award
under the Company's 2003 Stock Incentive Plan. The shares are payable and vest
over the same vesting schedule as the stock issued to the Manager. The cash
portion of the incentive fee of $15 thousand for the quarter ended December 31,
2003 was expensed in that period. In accordance with SFAS No. 123, and related
interpretations, and EITF 96-18, 15.2% of the restricted stock portion of the
incentive fees, or $2 thousand, was expensed in the quarter ended December 31,
2003. Included in other assets at December 31, 2003 is $13 thousand of deferred
compensation which will be reclassified to stockholders' equity after the
restricted stock is issued and will be expensed over the three-year vesting
period of the restricted stock. No incentive compensation was earned or paid to
the Chief Financial Officer for the period from April 26, 2003 to September 30,
2003.
F-18
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 8 -- RELATED PARTY TRANSACTIONS
At December 31, 2003, the Company was indebted to the Manager for base
management fees of $418 thousand, incentive fees of $606 thousand and
reimbursement of expenses of $16 thousand. At December 31, 2003, the Company was
indebted to the Company's Chief Financial Officer for incentive fees of $30
thousand and to officers and employees of the Company for expense reimbursement
of $18 thousand. These amounts are included in management fee payable, incentive
fee payable and other related party liabilities.
The Manager's financial relationship with the Company is governed by the
Management Agreement. Under the Management Agreement, the Manager shall be
responsible for all expenses of the personnel employed by the Manager, and all
facilities and overhead expenses of the Manager required for the day to day
operations of the Company, and the expenses of a sub-manager, if any. The
Company shall reimburse the Manager for its pro-rata portion of facilities and
overhead expenses to the extent that the Company's employees (who are not also
employed by the Manager) use such facilities or incur such expenses pursuant to
a cost-sharing agreement entered into between the Company and the Manager. As of
December 31, 2003, there were no expenses payable to the Manager pursuant to the
cost-sharing agreement. During the period April 26, 2003 through December 31,
2003, the Company paid the Manager $6 thousand pursuant to the cost-sharing
agreement. The Company shall pay all other expenses on behalf of the Company,
and shall reimburse the Manager for all direct expenses incurred on the
Company's behalf that are not the Manager's specific responsibility as defined
in the Management Agreement.
NOTE 9 -- FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, Disclosure About Fair Value of Financial Instruments,
requires disclosure of the fair value of financial instruments for which it is
practicable to estimate that value. The fair value of mortgage-backed securities
available-for-sale and futures contracts is equal to their carrying value
presented in the balance sheet. The fair value of cash and cash equivalents,
interest receivable, repurchase agreements, unsettled security purchases, note
payable, and accrued interest expense, approximates cost as of December 31, 2003
due to the short-term nature of these instruments.
NOTE 10 -- ACCUMULATED OTHER COMPREHENSIVE LOSS
The following is a summary of the components of accumulated other
comprehensive loss as of December 31, 2003:
NET UNREALIZED
LOSSES ON ACCUMULATED
MORTGAGE-BACKED NET UNREALIZED OTHER
SECURITIES LOSSES ON CASH COMPREHENSIVE
AVAILABLE-FOR-SALE FLOW HEDGES LOSS
------------------ -------------- -------------
(IN THOUSANDS)
Beginning Balance......................... $ -- $ -- $ --
Change during the period.................. (26,353) (157) (26,510)
-------- ----- --------
Ending Balance............................ $(26,353) $(157) $(26,510)
======== ===== ========
NOTE 11 -- INTEREST RATE RISK
The Company's primary component of market risk is interest rate risk. The
Company is subject to interest rate risk in connection with its investments in
fixed-rate, adjustable-rate and hybrid adjustable-rate mortgage-backed
securities, its related debt obligations, which are generally repurchase
agreements of limited duration that are periodically refinanced at current
market rates, and its derivative contracts. At December 31, 2003, 88.9% of the
Company's securities portfolio were hybrid adjustable-rate mortgage-
F-19
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
backed securities, 8.6% of the Company's securities were adjustable-rate
mortgage-backed securities and there were no fixed-rate mortgage-backed
securities.
The Company's strategy includes funding its investments in long-term,
fixed-rate and hybrid adjustable-rate mortgage-backed securities with short-term
borrowings under repurchase agreements. During periods of rising interest rates,
the borrowing costs associated with those fixed-rate and hybrid-adjustable rate
mortgage-backed securities tend to increase while the income earned on such
fixed-rate and hybrid adjustable-rate mortgage-backed securities (during the
fixed-rate component of such securities) may remain substantially unchanged.
This results in a narrowing of the net interest spread between the related
assets and borrowings and may even result in losses.
Among other strategies, the Company may use Eurodollar futures contracts
and interest rate swaps to manage interest rate risk and prepayment risk. The
effectiveness of any derivative transactions will depend significantly upon
whether the Company correctly quantifies the interest rate or prepayment risks
being hedged, execution of and ongoing monitoring of the Company's hedging
activities, and the treatment of such hedging activities for accounting
purposes. In the case of the Eurodollar futures contracts the Company had
outstanding at December 31, 2003, and any future efforts to hedge the effects of
interest rate changes on liability costs, if management enters into hedging
instruments that have higher interest rates imbedded in them as a result of the
forward yield curve, and at the end of the term of these hedging instruments the
spot market interest rates for the liabilities that are hedged are actually
lower, then the Company will have locked in higher interest rates for its
liabilities than would be available in the spot market at the time. This could
result in a narrowing of the Company's net interest margin or result in losses.
Prepayments are the full or partial repayment of principal prior to the
original term to maturity of a mortgage loan and typically occur due to
refinancing of mortgage loans. Prepayment rates for existing mortgage-backed
securities generally increase when prevailing interest rates fall below the
market rate existing when the underlying mortgages were originated. In addition,
prepayment rates on adjustable-rate and hybrid adjustable-rate mortgage-backed
securities generally increase when the difference between long-term and
short-term interest rates declines or becomes negative.
The Company intends to fund a substantial portion of its acquisitions of
adjustable-rate and hybrid adjustable-rate mortgage-backed securities with
borrowings that have interest rates based on indices and repricing terms similar
to, but of somewhat shorter maturities than, the interest rate indices and
repricing terms of the mortgage-backed securities. Thus, the Company anticipates
that in most cases the interest rate indices and repricing terms of its mortgage
assets and its funding sources will not be identical, thereby creating an
interest rate mismatch between assets and liabilities. Therefore, the Company's
cost of funds would likely rise or fall more quickly than would the Company's
earnings rate on assets. During periods of changing interest rates, such
interest rate mismatches could negatively impact the Company's financial
condition, cash flows and results of operations. To mitigate interest rate
mismatches, the Company may utilize hedging strategies discussed above and in
Note 12.
NOTE 12 -- DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company seeks to manage its interest rate risk exposure to protect the
Company's repurchase agreement liabilities against the effects of major interest
rate changes. Such interest rate risk may arise from the issuance and forecasted
rollover of short-term liabilities with fixed rate cash flows or from
liabilities with a contractual variable rate based on LIBOR. Among other
strategies, the Company may use Eurodollar futures contracts and interest rate
swaps to manage this interest rate risk. Derivative instruments are carried at
fair value.
F-20
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
The following table is a summary of derivative instruments held as of
December 31, 2003:
UNREALIZED UNREALIZED ESTIMATED
GAINS LOSSES FAIR VALUE
---------- ---------- ----------
(IN THOUSANDS)
Eurodollar futures contracts sold short.............. $3 $(160) $(157)
== ===== =====
CASH FLOW HEDGING STRATEGIES
Hedging instruments are designated as cash flow hedges, as appropriate,
based upon the specifically identified exposure, which may be an individual item
or a group of similar items. The hedged transaction is the forecasted interest
expense on forecasted rollover/reissuance of repurchase agreements for a
specified future time period and the hedged risk is the variability in those
payments due to changes in the benchmark rate. Hedging transactions are
structured at inception so that the notional amounts of the hedge are matched
with an equal amount of repurchase agreements forecasted to be outstanding in
that specified period for which the borrowing rate is not yet fixed. Cash flow
hedging strategies include the utilization of Eurodollar futures contracts and
interest rate swaps. Any ineffectiveness which arises during the hedging
relationship is recognized in interest expense during the period in which it
arises. Prior to the end of the specified hedge time period the effective
portion of all contract gains and losses (whether realized or unrealized) is
recorded in other comprehensive income or loss. Realized gains and losses are
reclassified into earnings as an adjustment to interest expense during the
specified hedge time period. Hedging instruments under these strategies are
deemed to be broadly designated to the outstanding repurchase portfolio and the
forecasted rollover thereof. Such forecasted rollovers would also include other
types of borrowing arrangements that may replace the repurchase funding during
the identified hedge time periods. At December 31, 2003, the maximum length of
time over which the Company is hedging its exposure is 12 months.
The Company may use Eurodollar futures contracts to hedge the forecasted
interest expense associated with the benchmark rate on forecasted
rollover/reissuance of repurchase agreements for a specified future time period,
which is defined as the calendar quarter immediately following the contract
expiration date. Gains and losses on each contract are associated with
forecasted interest expense for the specified future period.
The Company may use interest rate swaps to hedge the forecasted interest
expense associated with the benchmark rate on forecasted rollover/reissuance of
repurchase agreements for the period defined by maturity of the interest rate
swap. Cash flows that occur each time the swap is repriced will be associated
with forecasted interest expense for a specified future period, which is defined
as the calendar period preceding each repricing date with the same number of
months as the repricing frequency.
For the period from April 26, 2003 through December 31, 2003, there was no
gain or loss recognized in interest expense due to ineffectiveness. Based upon
the amounts included in accumulated other comprehensive income at December 31,
2003, the Company expects to recognize an increase of $157 thousand in interest
expense during 2004. This amount could differ from amounts actually realized due
to changes in the benchmark rate between December 31, 2003 and when the
Eurodollar futures contracts held at December 31, 2003 expire, as well as the
addition of other hedges subsequent to December 31, 2003.
F-21
LUMINENT MORTGAGE CAPITAL, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 13 -- SUMMARY OF QUARTERLY INFORMATION (UNAUDITED)
The following is a presentation of the results of operations for the period
from April 26, 2003 through June 30, 2003 and the quarters ended September 30,
2003 and December 31, 2003.
FOR THE PERIOD FOR THE FOR THE
FROM APRIL 26, QUARTER ENDED QUARTER ENDED
2003 THROUGH SEPTEMBER 30, DECEMBER 31,
JUNE 30, 2003 2003 2003
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS) -------------- ------------- --------------
Interest income................................ $ 672 $ 10,777 $ 11,205
Interest expense............................... 164 4,327 4,518
--------- ---------- ----------
Net interest income.......................... 508 6,450 6,687
Losses on sales of mortgage-backed securities... -- (7,831) --
Expenses....................................... 371 1,399 1,283
--------- ---------- ----------
Net income (loss).............................. $ 137 $ ( 2,780) $ 5,404
========= ========== ==========
Net income (loss) per share -- basic........... $ 0.04 $ (0.24) $ 0.40
========= ========== ==========
Net income (loss) per share -- diluted......... $ 0.04 $ (0.24) $ 0.40
========= ========== ==========
Weighted-average shares outstanding -- basic... 3,393,394 11,704,000 13,414,000
========= ========== ==========
Weighted-average shares outstanding -- diluted... 3,393,394 11,704,000 13,414,260
========= ========== ==========
NOTE 14 -- SUBSEQUENT EVENTS
On January 28, 2004, the Company filed an S-8 with the SEC to register up
to 1,000,000 shares of the Company's common stock, par value $0.001 per share,
to be issued or delivered pursuant to the Company's 2003 Stock Incentive Plan.
On February 4, 2004, the Company's Compensation Committee issued 25,651
shares of restricted stock to the Company's Manager in relation to the incentive
fees earned by the Manager during the quarter ended December 31, 2003. The
Manager subsequently assigned the restricted stock to employees of the Manager,
some of whom are also officers of the Company. On February 4, 2004, the
Company's Compensation Committee also issued 1,283 shares of restricted stock to
the Company's Chief Financial Officer under the 2003 Stock Incentive Plan in
relation to the incentive fees earned by the Chief Financial Officer during the
quarter ended December 31, 2003. On February 4, 2004, the Compensation Committee
also issued 212 shares of restricted stock under the 2003 Stock Incentive Plan
to the Company's Controller.
F-22
12,000,000 SHARES
(LUMINENT LOGO)
LUMINENT MORTGAGE CAPITAL, INC.
COMMON STOCK
-------------------------
PROSPECTUS
-------------------------
FRIEDMAN BILLINGS RAMSEY
CREDIT SUISSE FIRST BOSTON
JMP SECURITIES
FLAGSTONE SECURITIES
MARCH 29, 2004