UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
For the Quarterly Period Ended September 30, 2017
OR
For the transition period from to
Commission file number 814-00188
MEDALLION FINANCIAL CORP.
(Exact name of registrant as specified in its charter)
(IRS Employer
Identification No.)
437 MADISON AVENUE, 38th Floor,
NEW YORK, NEW YORK 10022
(Address of principal executive offices) (Zip Code)
(212) 328-2100
(Registrant’s telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES ☒ NO ☐
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or such shorter period that the Registrant was required to submit and post such files). YES ☐ NO ☐
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-acceleratedfiler, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (check one):
Emerging growth company ☐
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ☐ NO ☒
The number of outstanding shares of registrant’s Common Stock, par value $0.01, as of November 8, 2017 was 24,274,951.
TABLE OF CONTENTS
PART I – FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
PART II—OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 1A. RISK FACTORS
ITEM 6. EXHIBITS
SIGNATURES
CERTIFICATIONS
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BASIS OF PREPARATION
We, Medallion Financial Corp. or the Company, are a closed-end, non-diversified management investment company organized as a Delaware corporation. We have elected to be treated as a business development company, or BDC, under the Investment Company Act of 1940, as amended, or the 1940 Act. We are a specialty finance company that has historically had a leading position in originating, acquiring, and servicing loans that finance taxicab medallions and various types of commercial businesses. Recently, our strategic growth has been through a wholly-owned portfolio company of ours, Medallion Bank, which originates consumer loans for the purchase of recreational vehicles, boats, motorcycles, and trailers and to finance small-scale home improvements. Since Medallion Bank acquired a consumer loan portfolio and began originating consumer loans in 2004, it has increased its consumer loan portfolio at a compound annual growth rate of 18%. Since 1996, the year in which we became a public company, we have increased our taxicab medallion loan portfolio at a compound annual growth rate of 2%, and our commercial loan portfolio at a compound annual growth rate of 3% (6% and 3% on a managed basis when combined with Medallion Bank). In January 2017, we announced our plans to transform our overall strategy. We are transitioning away from medallion lending and placing our strategic focus on our growing consumer finance portfolio. Total assets under our management and the management of our unconsolidated wholly-owned subsidiaries, which includes our managed net investment portfolio, as well as assets serviced for third party investors, were $1,646,000,000 as of September 30, 2017, and $1,632,000,000 and $1,634,000,000 as of December 31, 2016 and September 30, 2016, and have grown at a compound annual growth rate of 10% from $215,000,000 at the end of 1996. Since our initial public offering in 1996, we have paid/declared distributions in excess of $263,060,000 or $14.66 per share.
We conduct our business through various wholly-owned investment company subsidiaries including:
We formed a wholly-owned portfolio company, Medallion Servicing Corporation, or MSC, to provide loan services to Medallion Bank, also a portfolio company wholly-owned by us. We have assigned all of our loan servicing rights for Medallion Bank, which consists of servicing taxi medallion and commercial loans originated by Medallion Bank, to MSC, which bills and collects the related service fee income from Medallion Bank, and is allocated and charged by us for MSC’s share of these servicing costs.
In addition, we conduct business through a wholly-owned portfolio company, Medallion Bank, a bank regulated by the FDIC and the Utah Department of Financial Institutions which originates consumer loans, raises deposits, and conducts other banking activities. Medallion Bank generally provides us with our lowest cost of funds which it raises through bank certificates of deposit. To take advantage of this low cost of funds, historically we have referred a portion of our taxicab medallion and commercial loans to Medallion Bank, who originated these loans, and have been serviced by MSC. However, at this time Medallion Bank is not originating any new taxi medallion loans and is working with MSC to service its existing portfolio. The FDIC restricts the amount of taxicab medallion loans that Medallion Bank may finance to three times Tier 1 capital, or $507,198,000 as of September 30, 2017. MSC earns referral and servicing fees for these activities. As anon-investment company, Medallion Bank is not consolidated with the Company, which is an investment company under the 1940 Act.
Our diversified investments in other controlled subsidiaries are comprised of Medallion Fine Art, Inc., Medallion Motorsports, LLC, Medallion Taxi Media, Inc., and LAX Group, LLC. In addition, we make other both marketable and nonmarketable equity investments.
The financial information is divided into two sections. The first section, Item 1, includes our unaudited consolidated financial statements including related footnotes. The second section, Item 2, consists of Management’s Discussion and Analysis of Financial Condition and Results of Operations for the quarter ended September 30, 2017.
Our consolidated balance sheet as of September 30, 2017, and the related consolidated statements of operations, changes in net assets, and cash flows for the three and nine months ended September 30, 2017 and 2016 included in Item 1 have been prepared by us, without audit, pursuant to the rules and regulations of the SEC. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the US have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the accompanying consolidated financial statements include all adjustments, which are of a normal and recurring nature, necessary to present fairly our consolidated financial position and results of operations. The results of operations for the three and nine months ended September 30, 2017 and 2016, or for any other interim period, may not be indicative of future performance. These financial statements should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2016.
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CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(Dollars in thousands, except per share data)
Interest income on investments
Dividend income from controlled subsidiaries
Interest income from affiliated investments
Interest income from controlled subsidiaries
Medallion lease income
Dividend income from affiliated investment
Dividends and interest income on short-term investments
Total investment income(1)
Total interest expense(2)
Net interest income
Total noninterest income
Salaries and benefits
Professional fees
Occupancy expense
Other operating expenses (3)
Total operating expenses
Net investment loss before income taxes(4)
Income tax (provision) benefit
Net investment loss after income taxes
Net realized gains (losses) on investments(5)
Income tax benefit
Total net realized gains (losses) on investments
Net change in unrealized appreciation on Medallion Bank and other controlled subsidiaries
Net change in unrealized depreciation on investments other than securities
Net change in unrealized appreciation (depreciation) on investments
Net unrealized appreciation (depreciation) on investments
Net realized/unrealized gains on investments
Net increase (decrease) in net assets resulting from operations
Net increase (decrease) in net assets resulting from operations per common share
Basic
Diluted
Distributions declared per share
Weighted average common shares outstanding
The accompanying notes should be read in conjunction with these consolidated financial statements.
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CONSOLIDATED BALANCE SHEETS
Assets
Medallion loans, at fair value
Commercial loans, at fair value
Commercial loans to affiliated entities, at fair value
Commercial loans to controlled subsidiaries, at fair value
Investment in Medallion Bank and other controlled subsidiaries, at fair value
Equity investments, at fair value
Equity investments in affiliated entities, at fair value
Net investments ($219,976 at September 30, 2017and $231,494 at December 31, 2016 pledged as collateral under borrowing arrangements)
Cash and cash equivalents ($7,850 at September 30, 2017 and $7,840 at December 31, 2016 restricted as to use by lender(1) )
Accrued interest receivable
Fixed assets, net
Investments other than securities(2)
Other assets, net
Total assets
Liabilities
Accounts payable and accrued expenses
Accrued interest payable
Deferred and other tax liabilities, net(3)
Funds borrowed
Total liabilities
Commitments and contingencies
Shareholders’ equity (net assets)
Preferred stock (1,000,000 shares of $0.01 par value stock authorized—none outstanding)
Common stock (50,000,000 shares of $0.01 par value stock authorized – 27,226,799shares at September 30, 2017 and 26,976,064 shares at December 31, 2016 issued)
Treasury stock at cost (2,951,243 shares at September 30,2017 and at December 31, 2016)
Capital in excess of par value
Accumulated undistributed net investment loss
Accumulated undistributed net realized gains on investments
Net unrealized appreciation on investments, net of tax
Total shareholders’ equity (net assets)
Total liabilities and shareholders’ equity
Number of common shares outstanding
Net asset value per share
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CONSOLIDATED STATEMENTS OF CHANGES IN NET ASSETS
Net realized gains (losses) on investments, net of tax
Net unrealized appreciation (depreciation) on investments, net of tax
Investment income, net
Return of capital
Realized gains from investment transactions, net
Distributions to shareholders(1)
Stock-based compensation expense
Exercise of stock options
Treasury stock acquired
Capital share transactions
Other, distributions not paid on forfeited restricted stock grants
Total increase (decrease) in net assets
Net assets at the beginning of the period
Net assets at the end of the period(2)
Capital share activity
Common stock issued, beginning of period
Issuance (forfeiture) of restricted stock, net
Common stock issued, end of period
Treasury stock, beginning of period
Treasury stock, end of period
Common stock outstanding
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES
Adjustments to reconcile net increase (decrease) in net assets resulting from operations to net cash provided by (used in) operating activities:
Investments originated(1)
Proceeds from principal receipts, sales, and maturities of investments(1)
Capital returned by (investment in) Medallion Bank and other controlled subsidiaries, net
Depreciation and amortization
Decrease in deferred and other tax liability, net
Amortization (accretion) of origination fees, net
Net change in unrealized depreciation on investments
Net change in unrealized depreciation on investment other than securities
Increase in unrealized appreciation on Medallion Bank and other controlled subsidiaries
Net realized (gains) losses on investments
Decrease in accrued interest receivable
Decrease (increase) in other assets, net
Increase (decrease) in accounts payable and accrued expenses
Increase in accrued interest payable
Net cash provided by (used for) operating activities
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from funds borrowed
Repayments of funds borrowed
Proceeds from exercise of stock options
Purchase of treasury stock at cost
Payments of declared distributions
Net cash provided by (used for) financing activities
NET DECREASE IN CASH AND CASH EQUIVALENTS
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
SUPPLEMENTAL INFORMATION
Cash paid during the period for interest
Cash paid during the period for income taxes
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2017
(1) ORGANIZATION OF MEDALLION FINANCIAL CORP. AND ITS SUBSIDIARIES
Medallion Financial Corp. (the Company), is a closed-end management investment company organized as a Delaware corporation. The Company has elected to be regulated as a business development company (BDC) under the Investment Company Act of 1940, as amended (the 1940 Act). The Company conducts its business through various wholly-owned subsidiaries including its primary operating company, Medallion Funding LLC (MFC), a Small Business Investment Company (SBIC) which originates and services taxicab medallion and commercial loans.
A wholly-owned portfolio investment, Medallion Bank, a Federal Deposit Insurance Corporation (FDIC) insured industrial bank, originates consumer loans, raises deposits, and conducts other banking activities (see Note 3). Medallion Bank is subject to competition from other financial institutions and to the regulations of certain federal and state agencies, and undergoes examinations by those agencies. Medallion Bank is not an investment company, and therefore, is not consolidated with the Company, but instead is treated as a portfolio investment. It was initially formed for the primary purpose of originating commercial loans in three categories: 1) loans to finance the purchase of taxicab medallions, 2) asset-based commercial loans, and 3) SBA 7(a) loans. The loans are marketed and serviced by Medallion Bank’s affiliates who have extensive prior experience in these asset groups. Subsequent to its formation, Medallion Bank began originating consumer loans to finance the purchases of RVs, boats, and other related items, and to finance small scale home improvements.
The Company formed a wholly-owned portfolio company, Medallion Servicing Corporation (MSC), to provide loan services to Medallion Bank, also a portfolio company wholly-owned by the Company. The Company has assigned all of its loan servicing rights for Medallion Bank, which consists of servicing taxi medallion and commercial loans originated by Medallion Bank, to MSC, who bills and collects the related service fee income from Medallion Bank, and is allocated and charged by the Company for MSC’s share of these servicing costs.
The Company also conducts business through Medallion Capital, Inc. (MCI), an SBIC which conducts a mezzanine financing business, and Freshstart Venture Capital Corp. (FSVC), an SBIC which originates and services taxicab medallion and commercial loans. MFC, MCI, and FSVC, as SBICs, are regulated by the Small Business Administration (SBA). MCI and FSVC are financed in part by the SBA.
MFC established a wholly-owned subsidiary, Taxi Medallion Loan Trust III (Trust III), for the purpose of owning medallion loans originated by MFC or others. Trust III is a separate legal and corporate entity with its own creditors who, in any liquidation of Trust III, will be entitled to be satisfied out of Trust III’s assets prior to any value in Trust III becoming available to Trust III’s equity holders. The assets of Trust III, aggregating $106,188,000 at September 30, 2017, are not available to pay obligations of its affiliates or any other party, and the assets of affiliates or any other party are not available to pay obligations of Trust III. Trust III’s loans are serviced by MFC.
The Company established a wholly-owned subsidiary, Medallion Financing Trust I (Fin Trust) for the purpose of issuing unsecured preferred securities to investors. Fin Trust is a separate legal and corporate entity with its own creditors who, in any liquidation of Fin Trust, will be entitled to be satisfied out of Fin Trust’s assets prior to any value in Fin Trust becoming available to Fin Trust’s equity holders. The assets of Fin Trust, aggregating $36,145,000 at September 30, 2017, are not available to pay obligations of its affiliates or any other party, and the assets of affiliates or any other party are not available to pay obligations of Fin Trust.
MFC through several wholly-owned subsidiaries (together, Medallion Chicago), purchased $8,689,000 of City of Chicago taxicab medallions out of foreclosure, which are leased to fleet operators while being held for sale. The 159 medallions are carried at a fair value of $9,510,000 on the consolidated balance sheet at September 30, 2017, compared to $9,510,000 and $19,020,000 at December 31, 2016 and September 30, 2016, and are considered non-qualifying assets under the 1940 Act.
(2) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates
The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the US requires management to make estimates that affect the amounts reported in the consolidated financial statements and the accompanying notes. Accounting estimates and assumptions are those that management considers to be the most critical to an understanding of the consolidated financial statements because they inherently involve significant judgments and uncertainties. All of
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these estimates reflect management’s best judgment about current economic and market conditions and their effects based on information available as of the date of these consolidated financial statements. If such conditions change, it is reasonably possible that the judgments and estimates could change, which may result in future impairments of loans and other receivables, investments other than securities, loans held for sale, and investments, among other effects.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, except for Medallion Bank and other portfolio investments. All significant intercompany transactions, balances, and profits have been eliminated in consolidation. As a non-investment company, Medallion Bank is not consolidated with the Company, which is an investment company under the 1940 Act. See Note 3 for the presentation of financial information for Medallion Bank and other controlled subsidiaries.
Cash and Cash Equivalents
The Company considers all highly liquid instruments with an original purchased maturity of three months or less to be cash equivalents. Cash balances are generally held in accounts at large national or regional banking organizations in amounts that exceed the federally insured limits, and includes $0 and $500,000 related to compensating balance requirements of regional banking institutions, and $7,850,000 and $7,840,000 pledged to a lender of an affiliate as of September 30, 2017 and December 31, 2016.
Fair Value of Assets and Liabilities
The Company follows FASB Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures, (FASB ASC 820), which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. FASB ASC 820 defines fair value as an exit price (i.e. a price that would be received to sell, as opposed to acquire, an asset or transfer a liability), and emphasizes that fair value is a market-based measurement. It establishes a fair value hierarchy that distinguishes between assumptions developed based on market data obtained from independent external sources and the reporting entity’s own assumptions. Further, it specifies that fair value measurement should consider adjustment for risk, such as the risk inherent in the valuation technique or its inputs. See also Notes 2, 12, and 13 to the consolidated financial statements.
Investment Valuation
The Company’s loans, net of participations and any unearned discount, are considered investment securities under the 1940 Act and are recorded at fair value. As part of the fair value methodology, loans are valued at cost adjusted for any unrealized appreciation (depreciation). Since no ready market exists for these loans, the fair value is determined in good faith by the Board of Directors. In determining the fair value, the Board of Directors considers factors such as the financial condition of the borrower, the adequacy of the collateral, individual credit risks, cash flows of the borrower, market condition for loans (e.g. values used by other lenders and any active bid/ask market), historical loss experience, and the relationships between current and projected market rates and portfolio rates of interest and maturities. Investments other than securities, which represent collateral received from defaulted borrowers, are valued similarly.
Equity investments (common stock and stock warrants, including certain controlled subsidiary portfolio investments) and investment securities (US Treasuries and mortgage backed bonds), in total representing 51% and 46% of the investment portfolio at September 30, 2017 and December 31, 2016, are recorded at fair value, represented as cost, plus or minus unrealized appreciation or depreciation. The fair value of investments that have no ready market are determined in good faith by the Board of Directors, based upon the financial condition and operating performance of the underlying investee companies as well as general market trends for businesses in the same industry. Included in equity investments were marketable securities of $16,000 and $537,000 at September 30, 2017 and December 31, 2016, and non-marketable securities of $9,968,000 and $7,931,000 in the comparable periods. The $303,861,000 and $293,360,000 related to portfolio investments in controlled subsidiaries at September 30, 2017 and December 31, 2016 were all non-marketable in each period. Because of the inherent uncertainty of valuations, the Board of Directors’ estimates of the values of the investments may differ significantly from the values that would have been used had a ready market for the investments existed, and the differences could be material.
The Company’s investment in Medallion Bank, as a wholly owned portfolio investment, is also subject to quarterly assessments of fair value. The Company conducts a thorough valuation analysis as described previously, and also receives an opinion regarding the valuation from an independent third party to assist the Board of Directors in its determination of the fair value of Medallion Bank on at least an annual basis. The Company’s analysis includes factors such as various regulatory restrictions that were established at Medallion Bank’s inception, by the FDIC and State of Utah, and also by additional regulatory restrictions, such as the prior moratorium imposed by the Dodd-Frank Act on the acquisition of control of an industrial bank by a “commercial firm” (a
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company whose gross revenues are primarily derived from non-financial activities) which expired in July 2013 and the lack of any new charter issuances since the moratorium’s expiration. Because of these restrictions and other factors, the Company’s Board of Directors had previously determined that Medallion Bank had little value beyond its recorded book value. As a result of this valuation process, the Company had previously used Medallion Bank’s actual results of operations as the best estimate of changes in fair value, and recorded the results as a component of unrealized appreciation (depreciation) on investments. In the second quarter of 2015, the Company first became aware of external interest in Medallion Bank and its portfolio’s assets at values in excess of their book value. Expression of interest in Medallion Bank from both investment bankers and interested parties has continued through 2016 and 2017. The Company incorporated these new factors in the Medallion Bank’s fair value analysis and the Board of Directors determined that Medallion Bank had a fair value in excess of book value. In addition, in the 2016 third quarter there was a court ruling involving a marketplace lender that the Company believes heightens the interest of marketplace lenders to acquire or merge with Utah industrial banks. The Company also engaged a valuation specialist to assist the Board of Directors in their determination of Medallion Bank’s fair value, and this appreciation of $15,500,000 was thereby recorded in 2015, and additional appreciation of $128,918,000 was recorded in 2016, and $563,000 was recorded in 2017. See Note 3 for additional information about Medallion Bank.
A majority of the Company’s investments consist of long-term loans to persons defined by SBA regulations as small business concerns. Approximately 36% and 41% of the Company’s investment portfolio at September 30, 2017 and December 31, 2016 had arisen in connection with the financing of taxicab medallions, taxicabs, and related assets, of which 68% and 69% were in New York City at September 30, 2017 and December 31, 2016. These loans are secured by the medallions, taxicabs, and related assets, and are personally guaranteed by the borrowers, or in the case of corporations, are generally guaranteed personally by the owners. A portion of the Company’s portfolio (13% at September 30, 2017 and December 31, 2016) represents loans to various commercial enterprises in a wide variety of industries, including manufacturing, retail trade, information, recreation, and various other industries. Approximately 51% of these loans are made primarily in the Midwest and 4% in the metropolitan New York City area, with the balance widely scattered across the United States. Investments in controlled unconsolidated subsidiaries, equity investments, and investment securities were 49%, 2%, and 0% at September 30, 2017, and were 45%, 1%, and 0% at December 31, 2016.
On a managed basis, which includes the investments of Medallion Bank after eliminating the Company’s investment in Medallion Bank, medallion loans were 28% and 35% at September 30, 2017 and December 31, 2016 (78% and 76% in New York City), commercial loans were 6% and 6%, and consumer loans were 52% and 46% in all 50 states collateralized by recreational vehicles, boats, motorcycles, trailers, and home improvements. Investment securities were 3% and 2% at September 30, 2017 and December 31, 2016, and equity investments (including investments in controlled subsidiaries) were 11% and 11%.
Investment Transactions and Income Recognition
Loan origination fees and certain direct origination costs are deferred and recognized as an adjustment to the yield of the related loans. At September 30, 2017 and December 31, 2016, net loan origination costs were $104,000 and $175,000. Net (accretion) amortization to income for the three months ended September 30, 2017 and 2016 was ($17,000) and ($66,000), and was ($55,000) and ($71,000) for the comparable nine month periods.
Investment securities are purchased from time-to-time in the open market at prices that are greater or lesser than the par value of the investment. The resulting premium or discount is deferred and recognized as an adjustment to the yield of the related investment. At September 30, 2017 and December 31, 2016, there were no premiums or discounts on investment securities, and their related income accretion or amortization was immaterial for 2017 and 2016.
Interest income is recorded on the accrual basis. Taxicab medallion and commercial loans are placed on nonaccrual status, and all uncollected accrued interest is reversed, when there is doubt as to the collectability of interest or principal, or if loans are 90 days or more past due, unless management has determined that they are both well-secured and in the process of collection. Interest income on nonaccrual loans is generally recognized when cash is received, unless a determination has been made to apply all cash receipts to principal. At September 30, 2017, December 31, 2016, and September 30, 2016, total nonaccrual loans were $132,316,000, $77,161,000, and $65,656,000, and represented 36%, 20%, and 17% of the gross medallion and commercial loan portfolio at each period end, and were primarily concentrated in the taxi medallion portfolio. The amount of interest income on nonaccrual loans that would have been recognized if the loans had been paying in accordance with their original terms was $16,286,000 ($9,750,000 of which had been applied to principal), $10,658,000, and $10,344,000 as of September 30, 2017, December 31, 2016, and September 30, 2016, of which $1,845,000 ($574,000 of which had been applied to principal) and $1,220,000 would have been recognized in the quarters ended September 30, 2017 and 2016, and $4,691,000 ($1,926,000 of which had been applied to principal) and $2,230,000 would have been recognized in the comparable nine months.
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Loan Sales and Servicing Fee Receivable
The Company accounts for its sales of loans in accordance with FASB Accounting Standards Codification Topic 860, Transfers and Servicing (FASB ASC 860) which provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. In accordance with FASB ASC 860, the Company has elected the fair value measurement method for its servicing assets and liabilities. The principal portion of loans serviced for others by the Company and its affiliates was $342,521,000 and $352,191,000 at September 30, 2017 and December 31, 2016, and included $314,974,000 and $325,751,000 of loans serviced for Medallion Bank. The Company has evaluated the servicing aspect of its business in accordance with FASB ASC 860, most of which relates to servicing assets held by Medallion Bank, and determined that no material servicing asset or liability exists as of September 30, 2017 and December 31, 2016. The Company has assigned its servicing rights to the Medallion Bank portfolio to MSC, a wholly-owned unconsolidated portfolio investment. The costs of servicing are allocated to MSC by the Company, and the servicing fee income is billed to and collected from Medallion Bank by MSC. During 2016, the Company exited the asset based lending business and sold the entire portfolio of $45,023,000, including $42,919,000 on the books of Medallion Bank, to a third party bank for a gain of $2,701,000, before deductions for closing costs.
Unrealized Appreciation (Depreciation) and Realized Gains (Losses) on Investments
Unrealized appreciation (depreciation) on investments is the amount by which the fair value estimated by the Company is greater (less) than the cost basis of the investment portfolio. Realized gains or losses on investments are generated through sales of investments, foreclosure on specific collateral, and writeoffs of loans or assets acquired in satisfaction of loans, net of recoveries. Unrealized appreciation (depreciation) on investments was $100,732,000, $127,367,000, and $53,509,000 as of September 30, 2017, December 31, 2016, and September 30, 2016. The Company’s investment in Medallion Bank, a wholly owned portfolio investment, is also subject to quarterly assessments of fair value. The Company conducts a thorough valuation analysis as described previously, and determines whether any factors give rise to a valuation different than recorded book value, including various regulatory restrictions that were established at Medallion Bank’s inception, by the FDIC and State of Utah, and also by additional marketplace restrictions, such as the ability to transfer industrial bank charters. Because of these restrictions and other factors, the Company’s Board of Directors had previously determined that Medallion Bank had little value beyond its recorded book value. As a result of this valuation process, the Company had previously used Medallion Bank’s actual results of operations as the best estimate of changes in fair value, and recorded the results as a component of unrealized appreciation (depreciation) on investments. In the second quarter of 2015, the Company became first aware of external interest in Medallion Bank and its portfolio assets at values in excess of their book value. Expression of interest in Medallion Bank from both investment bankers and interested parties has continued through 2016 and 2017. The Company incorporated these new factors in the Medallion Bank’s fair value analysis and the Board of Directors determined that Medallion Bank had a fair value in excess of book value. In addition, in the 2016 third quarter there was a court ruling involving a marketplace lender that the Company believes heightens the interest of marketplace lenders to acquire or merge with Utah industrial banks. The Company also engaged a valuation specialist to assist the Board of Directors in their determination of Medallion Bank’s fair value, and this appreciation of $15,500,000 was thereby recorded in 2015, and additional appreciation of $128,918,000 was recorded in 2016, and $563,000 was recorded in 2017. See Note 3 for additional information about Medallion Bank.
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The following tables set forth the pre-tax changes in the Company’s unrealized appreciation (depreciation) on investments for the 2017 and 2016 quarters shown below.
Balance December 31, 2016
Net change in unrealized
Appreciation on investments
Depreciation on investments
Reversal of unrealized appreciation (depreciation) related to realized
Gains on investments
Losses on investments
Balance March 31, 2017
Balance June 30, 2017
Balance September 30, 2017
Balance December 31, 2015
Balance March 31, 2016
Other
Balance June 30, 2016
Balance September 30, 2016
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The table below summarizes pre-tax components of unrealized and realized gains and losses in the investment portfolio for the three and nine months ended September 30, 2017 and 2016.
Unrealized appreciation
Unrealized depreciation
Net unrealized appreciation on investments in Medallion Bank and other controlled subsidiaries
Realized gains
Realized losses
Net unrealized losses on investments other than securities and other assets
Total
Net realized gains (losses) on investments
Other gains
Direct chargeoffs
Realized gains on investments other than securities and other assets
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The following table provides additional information on attributes of the nonperforming loan portfolio as of September 30, 2017, December 31, 2016, and September 30, 2016.
September 30, 2017
Medallion(3)
Commercial(3)
December 31, 2016
Commercial (3)
September 30, 2016
The following tables show the aging of medallion and commercial loans as of September 30, 2017 and December 31, 2016.
Recorded
Investment >
90 Days and
Medallion loans
Commercial loans
Secured mezzanine
Other secured commercial
Total commercial loans
A third party finance company sold various participations in asset based loans to Medallion Business Credit and Medallion Bank. In April 2013 the aggregate balance of the participations was approximately $13.8 million, $12.9 million of which were held by Medallion Bank. That amount was divided between seven separate borrowers operating in a variety of industries. In April 2013, the third party finance company became the subject of an involuntary bankruptcy petition filed by its bank lenders. Among other things, the bank lenders alleged that the third party finance company fraudulently misrepresented its borrowing availability under its credit facility with the bank lenders and are seeking the third party finance company’s liquidation. In May 2013, the bankruptcy court presiding over the third party finance company’s case entered an order converting the involuntary chapter 7 case to a chapter 11 case. The Company and Medallion Bank have placed these loans on nonaccrual, and reversed interest income. In
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addition, the Company and Medallion Bank have established valuation allowances against the outstanding balances. On May 31, 2013, the Company and Medallion Bank commenced an adverse proceeding against the third party finance company and the bank lenders seeking declaratory judgment that the Company’s and Medallion Bank’s loan participations are true participations and not subject to the bankruptcy estate or to the bank lender’s security interest in the third party finance company’s assets. The third party finance company and bank lenders are contesting the Company’s and Medallion Bank’s position. In April 2014, the Company and Medallion Bank received a decision from the court granting summary judgment in their favor with respect to the issue of whether the Company’s and Medallion Bank’s loan participations are true participations. In March 2015, the Company and Medallion Bank received a decision from the court finding that the bank lenders generally held a first lien on the Company’s and Medallion Bank’s loan participations subject to, among other things, defenses still pending prosecution by the parties and adjudication by the court. The Company and Medallion Bank are appealing the decision. The remaining issues are still being litigated. Although the Company and Medallion Bank believe the claims raised by the third party finance company and the bank lenders are without merit and will vigorously defend against them, the Company and Medallion Bank cannot at this time predict the outcome of this litigation or determine their potential exposure. At September 30, 2017, five of the seven secured borrowers had refinanced their loans in full with third parties, and the related proceeds are held in escrow pending resolution of the bankruptcy proceedings. In September 2015, one loan was sold at a discount to a third party, and the related proceeds are held in escrow pending resolution of the bankruptcy proceeding. One loan was charged off in September 2014. The balances related to the paid off loans have been reclassified to other assets on the consolidated balance sheet. The table below summarizes these receivables and their status with the Company and Medallion Bank as of September 30, 2017.
Loans outstanding
Loans charged off (1)
Valuation allowance
Net loans outstanding
Other receivables
Net other receivables
Total net outstanding
Income foregone in 2017
Total income foregone
The following table shows troubled debt restructurings which the Company entered into during the quarter ended September 30, 2017.
The following table shows troubled debt restructurings which the Company entered into during the nine months ended September 30, 2017.
During the twelve months ended September 30, 2017, sixteen loans modified as troubled debt restructurings were in default and had an investment value of $5,027,000 as of September 30, 2017, net of $4,495,000 of unrealized depreciation.
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The following table shows troubled debt restructurings which the Company entered into during the quarter and nine months ended September 30, 2016.
During the twelve months ended September 30, 2016, two loans modified as troubled debt restructurings were in default and had an investment value of $1,989,000 as of September 30, 2016.
Fixed Assets
Fixed assets are carried at cost less accumulated depreciation and amortization, and are depreciated on a straight-line basis over their estimated useful lives of 3 to 10 years. Leasehold improvements are amortized on a straight-line basis over the shorter of the lease term or the estimated economic useful life of the improvement. Depreciation and amortization expense was $23,000 and $28,000 for the quarters ended September 30, 2017 and 2016, and was $71,000 and $85,000 for the comparable nine months.
Deferred Costs
Deferred financing costs, included in other assets, represents costs associated with obtaining the Company’s borrowing facilities, and are amortized on a straight line basis over the lives of the related financing agreements. Amortization expense was $229,000 and $233,000 for the quarters ended September 30, 2017 and 2016, and was $697,000 and $486,000 for the comparable nine months, recorded as interest expense on the Consolidated Statement of Operations. In addition, the Company capitalizes certain costs for transactions in the process of completion (other than business combinations), including those for potential investments, and the sourcing of other financing alternatives. Upon completion or termination of the transaction, any accumulated amounts will be amortized against income over an appropriate period, or written off. The amounts on the balance sheet for all of these purposes were $3,295,000, $4,003,000, and $4,161,000 as of September 30, 2017, December 31, 2016, and September 30, 2016.
Income Taxes
Income taxes are accounted for using the asset and liability approach in accordance with FASB ASC Topic 740, Income Taxes (“ASC 740”). Deferred tax assets and liabilities reflect the impact of temporary differences between the carrying amount of assets and liabilities and their tax basis and are stated at tax rates expected to be in effect when taxes are actually paid or recovered. Deferred tax assets are also recorded for net operating losses, capital losses and any tax credit carryforwards. A valuation allowance is provided against a deferred tax asset when it is more likely than not that some or all of the deferred tax assets will not be realized. All available evidence, both positive and negative, is considered to determine whether a valuation allowance for deferred tax assets is needed. Items considered in determining our valuation allowance include expectations of future earnings of the appropriate tax character, recent historical financial results, tax planning strategies, the length of statutory carryforward periods and the expected timing of the reversal of temporary differences. Under ASC 740, forming a conclusion that a valuation allowance is not needed is difficult when there is negative evidence, such as cumulative losses in recent years. The Company recognizes tax benefits of uncertain tax positions only when the position is more likely than not to be sustained assuming examination by tax authorities. The Company records income tax related interest and penalties, if applicable, within current income tax expense. Through December 31, 2015 the Company qualified to be taxed as a RIC under the Code. Generally, a RIC is entitled to deduct dividends it pays to its shareholders from its income to determine taxable income.
Net Increase in Net Assets Resulting from Operations per Share (EPS)
Basic earnings per share are computed by dividing net increase in net assets resulting from operations available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if option contracts to issue common stock were exercised, or if restricted stock vests, and has been computed after giving consideration to the weighted average dilutive effect of the Company’s stock options and restricted stock. The Company uses the treasury stock method to calculate diluted EPS, which is a method of recognizing the use of proceeds that could be obtained upon exercise of options and warrants, including unvested compensation expense related to the shares, in computing diluted EPS. It assumes that any proceeds would be used to purchase common stock at the average market price during the period.
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The table below shows the calculation of basic and diluted EPS.
Net increase in net assets resulting from operations available to common shareholders
Weighted average common shares outstanding applicable to basic EPS
Effect of dilutive stock options
Effect of restricted stock grants
Adjusted weighted average common shares outstanding applicable to diluted EPS
Basic earnings per share
Diluted earnings per share
Potentially dilutive common shares excluded from the above calculations aggregated 359,000 and 347,000 shares as of September 30, 2017 and 2016.
Stock Compensation
The Company follows FASB Accounting Standard Codification Topic 718 (ASC 718), “Compensation – Stock Compensation”, for its stock option and restricted stock plans, and accordingly, the Company recognizes the expense of these grants as required. Stock-based employee compensation costs pertaining to stock options is reflected in net increase in net assets resulting from operations for any new grants using the fair values established by usage of the Black-Scholes option pricing model, expensed over the vesting period of the underlying option. Stock-based employee compensation costs pertaining to restricted stock are reflected in net increase in net assets resulting from operations for any new grants using the grant date fair value of the shares granted, expensed over the vesting period of the underlying stock.
During the nine months ended September 30, 2017 and 2016, the Company issued 258,232 restricted shares and 6,266 restricted shares of stock-based compensation awards, and 23,333 and 12,000 of other stock-based compensation awards, and recognized $222,000 and $551,000, or $0.01 and $0.02 per diluted common share for the 2017 third quarter and nine months, and $137,000 and $422,000, or $0.01 and $0.02 per share in the comparable 2016 periods, of non-cash stock-based compensation expense related to the grants. As of September 30, 2017, the total remaining unrecognized compensation cost related to unvested stock options and restricted stock was $367,000, which is expected to be recognized over the next 12 quarters (see Note 6).
Derivatives
The Company manages its exposure to increases in market rates of interest by periodically purchasing interest rate caps to lock in the cost of funds of its variable-rate debt in the event of a rapid run up in interest rates. The Company entered into contracts to purchase interest rate caps on $70,000,000 of notional value of principal from various multinational banks, with termination dates up to December 2018. The caps provide for payments to the Company if various LIBOR thresholds are exceeded during the cap terms. Total cap purchases were generally fully expensed when paid, including $0 and $19,000 for the three and nine months ended September 30, 2017 and $10,000 for the comparable 2016 periods, and all are carried at $0 on the balance sheet at September 30, 2017.
Reclassifications
Certain reclassifications have been made to prior year balances to conform with the current quarter’s presentation. These reclassifications have no effect on the previously reported results of operations.
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(3) INVESTMENT IN MEDALLION BANK AND OTHER CONTROLLED SUBSIDIARIES
The following table presents information derived from Medallion Bank’s statement of comprehensive income and other valuation adjustments on other controlled subsidiaries for the three and nine months ended September 30, 2017 and 2016.
Statement of comprehensive income
Investment income
Interest expense
Noninterest income
Operating expenses
Net investment income before income taxes
Income tax benefit (provision)
Net investment income after income taxes
Net realized/unrealized losses of Medallion Bank
Net increase in net assets resulting from operations of Medallion Bank
Unrealized appreciation (depreciation) on Medallion Bank (1)
Net realized/unrealized gains (losses) on controlled subsidiaries other than Medallion Bank
Net increase in net assets resulting from operations of Medallion Bank and other controlled subsidiaries
The following table presents Medallion Bank’s balance sheets and the net investment in other controlled subsidiaries as of September 30, 2017 and December 31, 2016.
Loans
Investment securities, at fair value
Net investments (1)
Cash
Other liabilities
Due to affiliates
Deposits and other borrowings, including accrued interest payable
Medallion Bank equity (2)
Total liabilities and equity
Investment in other controlled subsidiaries
Total investment in Medallion Bank and othercontrolled subsidiaries (3)
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The following paragraphs summarize the accounting and reporting policies of Medallion Bank, and provide additional information relating to the tables presented above.
Investment securities are purchased from time-to-time in the open market at prices that are greater or lesser than the par value of the investment. The resulting premium or discount is deferred and recognized on a level yield basis as an adjustment to the yield of the related investment. At September 30, 2017 and December 31, 2016, the net premium on investment securities totaled $250,000 and $238,000, and $21,000 and $61,000 was amortized into interest income for the quarter and nine months ended September 30, 2017, and $19,000 and $61,000 was amortized in the comparable 2016 periods.
Loan origination fees and certain direct origination costs are deferred and recognized as an adjustment to the yield of the related loans. At September 30, 2017 and December 31, 2016, net loan origination costs were $13,347,000 and $12,371,000. Net amortization expense for the quarter and nine months ended September 30, 2017 was $918,000 and $2,581,000, and was $947,000 and $2,688,000 for the comparable 2016 periods.
Medallion Bank’s policies regarding nonaccrual of medallion and commercial loans are similar to those of the Company. The consumer portfolio has different characteristics compared to commercial loans, typified by a larger number of lower dollar loans that have similar characteristics. These loans are placed on nonaccrual, when they become 90 days past due, or earlier if they enter bankruptcy, and are charged off in their entirety when deemed uncollectible, or when they become 120 days past due, whichever occurs first, at which time appropriate collection and recovery efforts against both the borrower and the underlying collateral are initiated. At September 30, 2017, $4,751,000 or less than 1% of consumer loans, no commercial loans, and $34,875,000 or 15% of medallion loans were on nonaccrual, compared to $4,179,000 or 1% of consumer loans, no commercial loans, and $47,841,000 or 16% of medallion loans on nonaccrual at December 31, 2016, and $3,467,000 or 1% of consumer loans, no commercial loans, and $47,403,000 or 15% of medallion loans on nonaccrual at September 30, 2016. The amount of interest income on nonaccrual loans that would have been recognized if the loans had been paying in accordance with their original terms was $1,278,000 (including $1,102,000 of interest paid on nonaccrual loans has been applied to principal), $514,000, and $1,161,000 as of September 30, 2017, December 31, 2016, and September 30, 2016. See also the paragraph and table on page 58 following the delinquency table for a discussion of other past due amounts.
Medallion Bank’s loan and investment portfolios are assessed for collectability on a monthly basis, and a loan loss allowance is established for any realizability concerns on specific investments, and general reserves have also been established for any unknown factors. Adjustments to the value of this portfolio are based on the Company’s own historical loan loss data developed since 2004, adjusted for changes in delinquency trends and other factors as described previously in Note 2.
Medallion Bank raises deposits to fund loan originations. The deposits were raised through the use of investment brokerage firms who package deposits qualifying for FDIC insurance into pools that are sold to Medallion Bank. The rates paid on the deposits are highly competitive with market rates paid by other financial institutions, and include a brokerage fee depending on the maturity of the deposit, which averages less than 0.15%, and which is capitalized and amortized to interest expense over the life of the respective pool. The total amount capitalized at September 30, 2017 and December 31, 2016 was $2,142,000 and $1,996,000, and $338,000 and $983,000 was amortized to interest expense during the quarter and nine months ended September 30, 2017, and $345,000 and $1,035,000 was amortized in the comparable 2016 periods. Interest on the deposits is accrued daily and paid monthly, quarterly, semiannually, or at maturity.
The outstanding balances of fixed rate borrowings were as follows.
Deposits and other borrowings
Medallion Bank is subject to various regulatory capital requirements administered by the FDIC and State of Utah Department of Financial Institutions. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional disciplinary actions by regulators that, if undertaken, could have a direct material effect on Medallion Bank’s and the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Medallion Bank must meet specific capital guidelines that involve quantitative measures of Medallion Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. Medallion Bank’s capital amounts and classification are also subject to qualitative judgments by Medallion Bank regulators about components, risk weightings, and other factors.
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FDIC-insured banks, including Medallion Bank, are subject to certain federal laws, which impose various legal limitations on the extent to which banks may finance or otherwise supply funds to certain of their affiliates. In particular, Medallion Bank is subject to certain restrictions on any extensions of credit to, or other covered transactions, such as certain purchases of assets, with the Company or its affiliates.
Quantitative measures established by regulation to ensure capital adequacy require Medallion Bank to maintain minimum amounts and ratios as defined in the regulations (set forth in the table below). Additionally, as conditions of granting Medallion Bank’s application for federal deposit insurance, the FDIC ordered that the leverage capital ratio (Tier 1 capital to average assets) be not less than 15%, and that an adequate allowance for loan losses be maintained. As a result, to facilitate maintenance of the capital ratio requirement and to provide the necessary capital for continued growth, the Company has periodically made capital contributions to Medallion Bank, including $3,000,000 in 2016. Separately, Medallion Bank declared dividends to the Company of $3,000,000 in the 2016 nine months.
On February 27, 2009 and December 22, 2009, Medallion Bank issued, and the US Treasury purchased under the TARP Capital Purchase Program (the CPP) Medallion Bank’s fixed rate non-cumulative Perpetual Preferred Stock, Series A, B, C, and D for an aggregate purchase price of $21,498,000 in cash. On July 21, 2011, Medallion Bank issued, and the US Treasury purchased 26,303 shares of Senior Non-Cumulative Perpetual Preferred Stock, Series E (Series E) for an aggregate purchase price of $26,303,000 under the Small Business Lending Fund Program (SBLF). The SBLF is a voluntary program intended to encourage small business lending by providing capital to qualified smaller banks at favorable rates. In connection with the issuance of the Series E, the Bank exited the CPP by redeeming the Series A, B, C, and D; and received approximately $4,000,000, net of dividends due on the repaid securities. The Bank previously paid a dividend rate of 1% on the Series E, which increased to 9% in the 2016 first quarter.
The following table represents Medallion Bank’s actual capital amounts and related ratios as of September 30, 2017 and December 31, 2016, compared to required regulatory minimum capital ratios and the ratios required to be considered well capitalized. As of September 30, 2017, Medallion Bank meets all capital adequacy requirements to which it is subject, and is well-capitalized.
(Dollars in Thousands)
Common equity tier 1 capital
Tier 1 capital
Total capital
Average assets
Risk-weighted assets
Leverage ratio (1)
Common equity tier 1 capital ratio (2)
Tier 1 capital ratio (3)
Total capital ratio (3)
(4) FUNDS BORROWED
The outstanding balances of funds borrowed were as follows.
DZ loan
Notes payable to banks
SBA debentures and borrowings
Retail notes
Preferred securities
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(A) DZ LOAN
In December 2008, Trust III entered into the DZ loan agreement with DZ Bank to provide up to $200,000,000 of financing through a commercial paper conduit to acquire medallion loans from MFC (DZ loan), which was extended in December 2013 until December 2016 through an amended and restated credit agreement, which has been further extended several times and currently terminates in March 2018. The line was reduced to $150,000,000, and was further reduced in stages lowering to $125,000,000 on July 1, 2016, and remains as an amortizing facility; and of which $101,354,000 was outstanding at September 30, 2017. During 2016 and 2017, the DZ loan was amended several times, for the most part to improve Trust III’s flexibility under the credit facility.
Borrowings under Trust III’s DZ loan are collateralized by Trust III’s assets. MFC is the servicer of the loans owned by Trust III. The DZ loan includes a borrowing base covenant and rapid amortization in certain circumstances. In addition, if certain financial tests are not met, MFC can be replaced as the servicer. The interest rate with the 2013 extension is a pooled short-term commercial paper rate which approximates LIBOR (30 day LIBOR was 1.23% at September 30, 2017) plus 1.65%.
(B) SBA DEBENTURES AND BORROWINGS
In 2016, the SBA approved $10,000,000 of commitments for MCI for a four and a half year term and a 1% fee, which was paid. In 2015, the SBA approved $15,500,000 of commitments for MCI for a four year term and a 1% fee, which was paid. In 2014, the SBA approved $10,000,000 of commitments for MCI for a four year term and a 1% fee, which was paid. In 2013, the SBA approved $23,000,000 and $5,000,000 of commitments for FSVC and MCI, respectively, for a four year term and a 1% fee, which was paid, and of which FSVC issued $23,000,000 of debentures, $18,150,000 of which was used to repay maturing debentures, and MCI issued $2,500,000 of debentures. During 2017, the SBA restructured FSVC’s debentures with SBA totaling $33,485,000 in principal into a new loan by the SBA to Freshstart in the principal amount of $34,024,756 (the “SBA Loan”). In connection with the SBA loan, FSVC executed a Note (the “SBA Note”), with an effective date of March 1, 2017, in favor of SBA, in the principal amount of $34,024,756. The SBA Loan bears interest at a rate of 3.25% per annum and requires a minimum of $5,500,000 of principal and interest to be paid on or before February 1, 2018, a minimum of $9,500,000 of principal and interest to be paid on or before February 1, 2019, and all remaining unpaid principal and interest on or before February 1, 2020, the final maturity date of the SBA Loan. The SBA Loan agreement contains covenants and events of defaults, including, without limitation, payment defaults, breaches of representations, and warranties and covenants defaults. As of September 30, 2017, $169,985,000 of commitments had been fully utilized, there were $5,500,000 of commitments available ($2,000,000 of which requires a $1,000,000 capital contribution from the Company), and $79,733,000 was outstanding, including $31,233,000 under the SBA Note.
(C) NOTES PAYABLE TO BANKS
The Company and its subsidiaries have entered into note agreements with a variety of local and regional banking institutions over the years. The notes are typically secured by various assets of the underlying borrower.
The table below summarizes the key attributes of the Company’s various borrowing arrangements with these lenders as of September 30, 2017.
Borrower
Type
Interest
Rate
Index(1)
The Company
Medallion Chicago
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(D) PREFERRED SECURITIES
In June 2007, the Company issued and sold $36,083,000 aggregate principal amount of unsecured junior subordinated notes to Fin Trust which, in turn, sold $35,000,000 of preferred securities to Merrill Lynch International and issued 1,083 shares of common stock to the Company. The notes bear a variable rate of interest of 90 day LIBOR (1.33% at September 30, 2017) plus 2.13%. The notes mature in September 2037 and are prepayable at par. Interest is payable quarterly in arrears. The terms of the preferred securities and the notes are substantially identical. In December 2007, $2,000,000 of the preferred securities were repurchased from a third party investor. At September 30, 2017, $33,000,000 was outstanding on the preferred securities.
(E) MARGIN LOAN
In June 2015, the Company entered into a margin loan agreement with Morgan Stanley. The margin loan is secured by the pledge of short-term, high-quality investment securities held by the Company, and is initially available at 90% of the current fair
market value of the securities. The margin loan bears interest at 30-day LIBOR (1.23% at September 30, 2017) plus 1.00%. As of September 30, 2017, there were no outstandings under the margin loan.
(F) RETAIL NOTES
In April 2016, the Company issued a total of $33,625,000 aggregate principal amount of 9.00% unsecured notes due 2021, with interest payable quarterly in arrears. The Company used the net proceeds from the offering of approximately $31,786,000 to make loans and other investments in portfolio companies and for general corporate purposes, including repaying borrowings under its DZ loan in the ordinary course of business.
(G) COVENANT COMPLIANCE
Certain of the Company’s debt agreements contain restrictions that require the Company and its subsidiaries to maintain certain financial ratios, including debt to equity and minimum net worth. The Company is in compliance with such restrictions as of September 30, 2017.
(5) INCOME TAXES
Through December 31, 2015, the Company qualified to be taxed as a RIC under Subchapter M of the Code. A RIC is not subject to federal income tax on the portion of its taxable ordinary income and net long-term capital gains that are distributed to its shareholders. For the tax year ended December 31, 2015, the Company had an ordinary loss for tax purposes.
During 2016, the Company’s assets did not meet the quarterly investment diversification requirements to qualify as a RIC, primarily due to the increase in Medallion Bank’s fair value. Therefore, for the year ended December 31, 2016, the Company became subject to taxation as a regular corporation under Subchapter C of the Code. This change in tax status does not affect the Company’s status as a BDC under the 1940 Act or its compliance with the portfolio composition requirements of that statute.
As a result of being taxed as a corporation under Subchapter C, the Company is subject to federal and applicable state corporate income taxes on its taxable ordinary income and capital gains.
As a corporation taxed under Subchapter C, the Company is able, and intends, to file a consolidated federal income tax return with corporate subsidiaries, including portfolio companies such as Medallion Bank, in which it holds 80 percent or more of the outstanding equity interest measured by both vote and fair value.
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The following table sets forth the significant components of our deferred and other tax assets and liabilities as of September 30, 2017 and December 31, 2016.
Unrealized gain on investment in Medallion Bank
Unrealized losses on loans and nonaccrual interest
Unrealized gain on investments in other controlled subsidiaries
Unrealized gains on investments other than securities
Accrued expenses, compensation
Net operating loss carryforwards(1)
Unrealized gains on other investments
Total deferred tax liability
Deferred tax liability, net
Taxes receivable (payable)
Net deferred and other tax liabilities
The components of our tax benefit for the three and nine months ended September 30, 2017 and 2016 were as follows.
Current
Federal
State
Deferred
Net benefit for income taxes
The following table presents a reconciliation of statutory federal income tax benefit to consolidated actual income tax benefit reported in net increase in net assets for the three and nine months ended September 30, 2017 and 2016.
Statutory Federal Income tax benefit at 35%
State and local income taxes, net of federal income tax benefit
Change in effective state income tax rate
Appreciation of Medallion Bank
Depreciation of other unconsolidated subsidiaries
Utilization of carry forwards
Total income tax benefit
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which temporary differences become deductible pursuant to ASC 740. The Company considers the reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. The Company’s evaluation of the realizability of deferred tax assets must consider both positive and negative evidence. The weight given to the potential effects of positive and negative evidence is based on the extent to which it can be objectively verified. It is based upon these considerations by which the Company has determined the valuation allowance deemed necessary as of September 30, 2017.
The Company has filed tax returns in many states. Federal, New York State, and New York City tax filings of the Company for the tax years 2014 through the present are the more significant filings that are open for examination.
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(6) STOCK OPTIONS AND RESTRICTED STOCK
The Company has a stock option plan (2006 Stock Option Plan) available to grant both incentive and nonqualified stock options to employees. The 2006 Stock Option Plan, which was approved by the Board of Directors on February 15, 2006 and shareholders on June 16, 2006, provided for the issuance of a maximum of 800,000 shares of common stock of the Company. No additional shares are available for issuance under the 2006 Stock Option Plan. The 2006 Stock Option Plan is administered by the Compensation Committee of the Board of Directors. The option price per share may not be less than the current market value of the Company’s common stock on the date the option is granted. The term and vesting periods of the options are determined by the Compensation Committee, provided that the maximum term of an option may not exceed a period of ten years.
The Company’s Board of Directors approved the 2015 Employee Restricted Stock Plan (2015 Restricted Stock Plan) on February 13, 2015 and which was approved by the Company’s shareholders on June 5, 2015. The 2015 Restricted Stock Plan became effective upon the Company’s receipt of exemptive relief from the SEC on March 1, 2016. The terms of 2015 Restricted Stock Plan provide for grants of restricted stock awards to the Company’s employees. A grant of restricted stock is a grant of shares of the Company’s common stock which, at the time of issuance, is subject to certain forfeiture provisions, and thus is restricted as to transferability until such forfeiture restrictions have lapsed. A total of 700,000 shares of the Company’s common stock are issuable under the 2015 Restricted Stock Plan, and 400,331 remained issuable as of September 30, 2017. Awards under the 2015 Restricted Stock Plan are subject to certain limitations as set forth in the 2015 Restricted Stock Plan. The 2015 Restricted Stock Plan will terminate when all shares of common stock authorized for delivery under the 2015 Restricted Stock Plan have been delivered and the forfeiture restrictions on all awards have lapsed, or by action of the Board of Directors pursuant to the 2015 Restricted Stock Plan, whichever first occurs.
The Company’s Board of Directors approved the 2009 Employee Restricted Stock Plan (the Employee Restricted Stock Plan) on April 16, 2009. The Employee Restricted Stock Plan became effective upon the Company’s receipt of exemptive relief from the SEC and approval of the Employee Restricted Stock Option Plan by the Company’s shareholders on June 11, 2010. No additional shares are available for issuance under the Employee Restricted Stock Plan. The terms of the Employee Restricted Stock Plan provided for grants of restricted stock awards to the Company’s employees. A grant of restricted stock is a grant of shares of the Company’s common stock which, at the time of issuance, is subject to certain forfeiture provisions, and thus is restricted as to transferability until such forfeiture restrictions have lapsed. A total of 800,000 shares of the Company’s common stock were issuable under the Employee Restricted Stock Plan, and as of September 30, 2017, none of the Company’s common stock remained available for future grants. Awards under the 2009 Employee Plan are subject to certain limitations as set forth in the Employee Restricted Stock Plan. The Employee Restricted Stock Plan will terminate when all shares of common stock authorized for delivery under the Employee Restricted Stock Plan have been delivered and the forfeiture restrictions on all awards have lapsed, or by action of the Board of Directors pursuant to the Employee Restricted Stock Plan, whichever first occurs.
The Company’s Board of Directors approved the 2015 Non-Employee Director Stock Option Plan (2015 Director Plan) on March 12, 2015, which was approved by the Company’s shareholders on June 5, 2015, and on which exemptive relief to implement the 2015 Director Plan was received from the SEC on February 29, 2016. A total of 300,000 shares of the Company’s common stock are issuable under the 2015 Director Plan, and 264,667 remained issuable as of September 30, 2017. Under the 2015 Director Plan, unless otherwise determined by a committee of the Board of Directors comprised of directors who are not eligible for grants under the 2015 Director Plan, the Company will grant options to purchase 12,000 shares of the Company’s common stock to a non-employeedirector upon election to the Board of Directors, with an adjustment for directors who are elected to serve less than a full term. The option price per share may not be less than the current market value of the Company’s common stock on the date the option is granted. Options granted under the 2015 Director Plan are exercisable annually, as defined in the 2015 Director Plan. The term of the options may not exceed ten years.
The Company’s Board of Directors approved the First Amended and Restated 2006 Director Plan (the Amended Director Plan) on April 16, 2009, which was approved by the Company’s shareholders on June 5, 2009, and on which exemptive relief to implement the Amended Director Plan was received from the SEC on July 17, 2012. A total of 200,000 shares of the Company’s common stock were issuable under the Amended Director Plan. No additional shares are available for issuance under the Amended Director Plan. Under the Amended Director Plan, unless otherwise determined by a committee of the Board of Directors comprised of directors who are not eligible for grants under the Amended Director Plan, the Company will grant options to purchase 9,000 shares of the Company’s common stock to an Eligible Director upon election to the Board of Directors, with an adjustment for directors who are elected to serve less than a full term. The option price per share may not be less than the current market value of the Company’s common stock on the date the option is granted. Options granted under the Amended Director Plan are exercisable annually, as defined in the Amended Director Plan. The term of the options may not exceed ten years.
No additional shares are available for future issuance under the Employee Restricted Stock Plan and the Amended Director Plan. At September 30, 2017, 314,293 options on the Company’s common stock were outstanding under the 2006, and 2015 plans, of which 273,960 options were exercisable, and there were 345,470 unvested shares of the Company’s common stock outstanding under the Employee Restricted Stock Plan.
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The fair value of each restricted stock grant is determined on the date of grant by the closing market price of the Company’s common stock on the grant date. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model. The weighted average fair value of the options granted was $0.29 and $0.53 for the nine months ended September 30, 2017 and 2016. The following assumption categories are used to determine the value of any option grants.
Risk free interest rate
Expected dividend yield
Expected life of option in years (1)
Expected volatility (2)
The following table presents the activity for the stock option programs for the 2017 quarters and the 2016 full year.
Outstanding at December 31, 2015
Granted
Cancelled
Exercised (1)
Outstanding at December 31, 2016
Outstanding at March 31, 2017
Outstanding at June 30, 2017
Outstanding at September 30, 2017(2)
Options exercisable at September 30, 2017 (2)
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The following table presents the activity for the restricted stock programs for the 2017 quarters and the 2016 full year.
Vested (1)
Vested(1)
The following table presents the activity for the unvested options outstanding under the plans for the 2017 quarters.
Outstanding at December 31, 2016 and March 31, 2017
Vested
Outstanding at September 30, 2017
The intrinsic value of the options vested was $0 for the 2017 third quarter and nine months.
(7) SEGMENT REPORTING
The Company has one business segment, its lending and investing operations. This segment originates and services medallion, secured commercial, and consumer loans, and invests in both marketable and nonmarketable securities.
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(8) OTHER OPERATING EXPENSES
The major components of other operating expenses were as follows:
Travel, meals, and entertainment
Directors’ fees
Miscellaneous taxes
Bad debt expense
Computer expenses
Insurance
Office expense
Printing and stationery
Dues and subscriptions
Other expenses
Total other operating expenses
(9) SELECTED FINANCIAL RATIOS AND OTHER DATA
The following table provides selected financial ratios and other data:
Net share data
Net asset value at the beginning of the period
Net investment income (loss)
Net realized gains on investments
Issuance of common stock
Repurchase of common stock
Net investment income
Total distributions
Total increase (decrease) in net asset value
Net asset value at the end of the period(1)
Per share market value at beginning of period
Per share market value at end of period
Total return (2)
Ratios/supplemental data
Average net assets
Total expense ratio (3) (4)
Operating expenses to average net assets(4)
Net investment income after income taxes to average net assets(4)
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(10) RECENTLY ISSUED ACCOUNTING STANDARDS
In May 2017, the FASB issued Accounting Standards Update (ASU) 2017-09. Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting. The objective of this update is to provide clarity and reduce both diversity in practice and cost and complexity when applying the guidance of Topic 718. The amendments in this update are effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The Company is assessing the impact the update will have on its financial condition and results of operations.
In January 2017, the FASB issued ASU 2017-04. Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment. The objective of this update is to simplify the subsequent measurement of goodwill, by eliminating step 2 from the goodwill impairment test. The amendments in this update are effective for annual periods beginning after December 15, 2019, and interim periods within those fiscal years. The Company does not believe this update will have a material impact on its financial condition.
In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The update clarifies how entities should classify certain cash receipts and cash payments on the statement of cash flows with the objective of reducing the existing diversity in practice related to eight specific cash flow issues. The amendments in this update are effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. The Company does not expect the adoption of ASU 2016-15 to have a material impact on its consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). ASU 2016-02 requires the recognition of lease assets and lease liabilities by lessees for leases classified as operating under current GAAP. ASU 2016-02 applies to all entities and is effective for fiscal years beginning after December 15, 2018 for public entities and is effective for fiscal years beginning after December 15, 2019 for all other entities, with early adoption permitted. The Company is assessing the impact the update will have on its financial condition and results of operations.
In January 2016, the FASB issued ASU 2016-01, Financial Instruments - Overall (Topic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The main objective of this Update is to enhance the reporting model for financial instruments and provide users of financial statements with more decision-useful information. ASU 2016-01 requires equity investments to be measured at fair value, simplifies the impairment assessment of equity investment without readily determinable fair value, eliminates the requirements to disclose the fair value of financial instruments measured at amortized cost, and requires public business entities to use the exit price notion when measuring the fair value of financial instruments. The update, as amended, is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. The Company does not believe this update will have a material impact on its financial condition.
(11) RELATED PARTY TRANSACTIONS
Certain directors, officers, and shareholders of the Company are also directors and officers of its wholly-owned subsidiaries, MFC, MCI, FSVC, and Medallion Bank, as well as of certain portfolio investment companies. Officer salaries are set by the Board of Directors of the Company.
Jeffrey Rudnick, the son of one of the Company’s directors, is an officer of LAX Group, LLC (LAX), one of the Company’s portfolio companies. Mr. Rudnick receives a salary from LAX of $166,000 per year, and certain equity from LAX consisting of 10% ownership in LAX Class B stock, vesting at 3.34% per year; 5% of any new equity raised from outside investors at a valuation of $1,500,000 or higher; and 10% of LAX’s profits as a year end bonus. In addition, Mr. Rudnick provides consulting services to the Company directly for a monthly retainer of $4,200.
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At September 30, 2017, December 31, 2016, and September 30, 2016, the Company and MSC serviced $314,974,000, $325,751,000, and $329,304,000 of loans for Medallion Bank. Included in net investment income were amounts as described in the table below that were received from Medallion Bank for services rendered in originating and servicing loans, and also for reimbursement of certain expenses incurred on their behalf.
The Company has assigned its servicing rights to the Medallion Bank portfolio to MSC, a wholly-owned unconsolidated portfolio investment. The costs of servicing are allocated to MSC by the Company, and the servicing fee income is billed and collected from Medallion Bank by MSC. As a result, $1,330,000 and $3,938,000 of servicing fee income was earned by MSC in the 2017 third quarter and nine months, and $1,416,000 and $4,231,000 was earned in the comparable 2016 periods.
The following table summarizes the net revenues received from Medallion Bank.
Reimbursement of operating expenses
Loan origination and servicing fees
Total other income
The Company had a loan to Medallion Fine Art, Inc. in the amount of $1,167,000 and $3,159,000 as of September 30, 2017 and December 31, 2016. The loan bears interest at a rate of 12%, all of which is paid in kind. During 2017 and 2016, the Company advanced $0 and $300,000, and was repaid $2,165,000 and $6,111,000 with respect to this loan. Additionally, the Company recognized $38,000 and $163,000 of interest income in the three and nine months ended September 30, 2017, and $99,000 and $504,000 in the comparable 2016 periods with respect to this loan.
The Company and MCI had loans to RPAC Racing LLC, an affiliate of Medallion Motorsports LLC which totaled $8,645,000 and $8,589,000 as of September 30, 2017 and December 31, 2016, and which were placed on nonaccrual effective July 1, 2017. The loans bear interest at rates of 9.9% and 2%, all of which is paid in kind. The Company and MCI recognized $0 and $56,000 of interest income for the three and nine months ended September 30, 2017, and $174,000 and $429,000 for the comparable 2016 periods with respect to these loans.
(12) FAIR VALUE OF FINANCIAL INSTRUMENTS
FASB ASC Topic 825, Financial Instruments, requires disclosure of fair value information about certain financial instruments, whether assets, liabilities, or off-balance-sheet commitments, if practicable. The following methods and assumptions were used to estimate the fair value of each class of financial instrument. Fair value estimates that were derived from broker quotes cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument.
(a) Investments—The Company’s investments are recorded at the estimated fair value of such investments.
(b) Floating rate borrowings—Due to the short-term nature of these instruments, the carrying amount approximates fair value.
(c) Commitments to extend credit—The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and present creditworthiness of the counter parties. For fixed rate loan commitments, fair value also includes a consideration of the difference between the current levels of interest rates and the committed rates. At September 30, 2017 and December 31, 2016, the estimated fair value of theseoff-balance-sheet instruments was not material.
(d) Fixed rateborrowings - The fair value of the debentures payable to the SBA is estimated based on current market interest rates for similar debt.
Financial assets
Investments
Cash (1)
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Accrued interest receivable (2)
Financial liabilities
Funds borrowed (3)
Accrued interest payable (2)
(13) FAIR VALUE OF ASSETS AND LIABILITIES
The Company follows the provisions of FASB ASC 820, which defines fair value, establishes a framework for measuring fair value, establishes a fair value hierarchy based on the quality of inputs used to measure fair value, and enhances disclosure requirements for fair value measurements. The Company accounts for substantially all of its financial instruments at fair value or considers fair value in its measurement, in accordance with the accounting guidance for investment companies. See Note 2 sections “Fair Value of Assets and Liabilities” and “Investment Valuation” for a description of our valuation methodology which is unchanged during 2017.
In accordance with FASB ASC 820, the Company has categorized its assets and liabilities measured at fair value, based on the priority of the inputs to the valuation technique, into a three-level fair value hierarchy. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (level 1) and the lowest priority to unobservable inputs (level 3). Our assessment and classification of an investment within a level can change over time based upon maturity or liquidity of the investment and would be reflected at the beginning of the quarter in which the change occurred.
As required by FASB ASC 820, when the inputs used to measure fair value fall within different levels of the hierarchy, the level within which the fair value measurement is categorized is based on the lowest level input that is significant to the fair value measurement in its entirety. For example, a level 3 fair value measurement may include inputs that are observable (level 1 and 2) and unobservable (level 3). Therefore gains and losses for such assets and liabilities categorized within the level 3 table below may include changes in fair value that are attributable to both observable inputs (level 1 and 2) and unobservable inputs (level 3).
Assets and liabilities measured at fair value, recorded on the consolidated balance sheets, are categorized based on the inputs to the valuation techniques as follows:
Level 1. Assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market that the Company has the ability to access (examples include active exchange-traded equity securities, exchange-traded derivatives, most US Government and agency securities, and certain other sovereign government obligations).
Level 2. Assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following:
Level 3. Assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the assets or liability (examples include certain private equity investments, and certain residential and commercial mortgage-related assets, including loans, securities, and derivatives).
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A review of fair value hierarchy classification is conducted on a quarterly basis. Changes in the observability of valuation inputs may result in a reclassification for certain assets or liabilities. Reclassifications impacting level 3 of the fair value hierarchy are reported as transfers in/out of the level 3 category as of the beginning of the quarter in which the reclassifications occur. The following paragraphs describe the sensitivity of the various level 3 valuations to the factors that are relevant in their valuation analysis.
Medallion loans are primarily collateral-based lending, whereby the collateral value exceeds the amount of the loan, providing sufficient excess collateral to protect against losses to the Company. As a result, the initial valuation assessment is that as long as the loan is current and performing, its fair value approximates the par value of the loan. To the extent a loan becomes nonperforming, the collateral value has been adequate to result in a complete recovery. In a case where the collateral value was inadequate, an unrealized loss would be recorded to reflect any shortfall. Collateral values for medallion loans are typically obtained from transfer prices reported by the regulatory agency in a particular local market (e.g. New York City Taxi and Limousine Commission). Recently, as transfer price activity and the collateral value of medallion loans has declined, and greater weight has been placed on the operating cash flows of the borrowers and the values of their personal guarantees in determining whether or not a valuation adjustment is necessary. Those portfolios had historically been at very low loan to collateral value ratios, and as a result, historically have not been highly sensitive to changes in collateral values. Over the last few years, as medallion collateral values have declined, the impact on the Company’s valuation analysis has become more significant, which could result in a significantly lower fair value measurement.
The mezzanine and other secured commercial portions of the commercial loan portfolio are a combination of cash flow and collateral based lending. The initial valuation assessment is that as long as the loan is current and performing, its fair value approximates the par value of the loan. If a loan becomes nonperforming, an evaluation is performed which considers and analyzes a variety of factors which may include the financial condition and operating performance of the borrower, the adequacy of the collateral, individual credit risks, historical loss experience, the relationships between current and projected market rates and portfolio rates of interest and maturities, as well as general market trends for businesses in the same industry. Since each individual nonperforming loan has its own unique attributes, the factors analyzed, and their relative importance to each valuation analysis, differ between each asset, and may differ from period to period for a particular asset. The valuation is highly sensitive to changes in the assumptions used. To the extent that any assumption in the analysis changes significantly from one period to another, that change could result in a significantly lower or higher fair market value measurement. For example, if a borrower’s valuation was determined primarily on the cash flow generated from their business, then if that cash flow deteriorated significantly from a prior period valuation, that could have a material impact on the valuation in the current period.
The investment in Medallion Bank is subject to a thorough valuation analysis as described previously, and on an annual basis, the Company also receives an opinion regarding the valuation from an independent third party to assist the Board of Directors in its determination of the fair value. The Company determines whether any factors give rise to a valuation different than recorded book value, including various regulatory restrictions that were established at Medallion Bank’s inception, by the FDIC and State of Utah, and also by additional regulatory restrictions, such as the prior moratorium imposed by the Dodd-Frank Act on the acquisition of control of an industrial bank by a “commercial firm” (a company whose gross revenues are primarily derived from non-financial activities) which expired in July 2013, and the lack of any new charter issuances since the moratorium’s expiration. Because of these restrictions and other factors, the Company’s Board of Directors had previously determined that Medallion Bank had little value beyond its recorded book value. As a result of this valuation process, the Company had previously used Medallion Bank’s actual results of operations as the best estimate of changes in fair value, and recorded the results as a component of unrealized appreciation (depreciation) on investments In the second quarter of 2015, the Company first became aware of external interest in Medallion Bank and its portfolio’s assets at values in excess of their book value. Expression of interest in Medallion Bank from both investment bankers and interested parties has continued through 2016 and 2017. The Company incorporated these new factors in the Medallion Bank’s fair value analysis and the Board of Directors determined that Medallion Bank had a fair value in excess of book value. In addition, in the 2016 third quarter there was a court ruling involving a marketplace lender that the Company believes heightens the interest of marketplace lenders to acquire or merge with Utah industrial banks. The Company also engaged a valuation specialist to assist the Board of Directors in their determination of Medallion Bank’s fair value, and this appreciation of $15,500,000 was thereby recorded in 2015, $128,918,000 was recorded in 2016, and additional appreciation of $563,000 was recorded in 2017. See Note 3 for additional information about Medallion Bank.
Investments in controlled subsidiaries, other than Medallion Bank, equity investments, and investments other than securities are valued similarly, while also considering available current market data, including relevant and applicable market trading and transaction comparables, the nature and realizable value of any collateral, applicable interest rates and market yields, the portfolio company’s ability to make payments, its earnings and cash flows, the markets in which the portfolio company does business, and borrower financial analysis, among other factors. As a result of this valuation process, the Company uses the actual results of operations of the controlled subsidiaries as the best estimate of changes in fair value, in most cases, and records the results as a component of unrealized appreciation (depreciation) on investments. For the balance of controlled subsidiary investments, equity investments, and investments other than securities positions, the result of the analysis results in changes to the value of the position if
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there is clear evidence that it’s value has either decreased or increased in light of the specific facts considered for each investment. The valuation is highly sensitive to changes in the assumptions used. To the extent that any assumption in the analysis changes significantly from one period to another, that change could result in a significantly lower or higher fair market value measurement. For example, if an investee’s valuation was determined primarily on the cash flow generated from their business, then if that cash flow deteriorated significantly from a prior period valuation, that could have a material impact on the valuation in the current period.
The following tables present the Company’s fair value hierarchy for those assets and liabilities measured at fair value on a recurring basis as of September 30, 2017 and December 31, 2016.
2017 Assets
Investment in Medallion Bank and other controlled subsidiaries
Equity investments
Investment other than securities
Other assets
2016 Assets
Investments other than securities
Included in level 3 investments in Medallion Bank and other controlled subsidiaries is primarily the investment in Medallion Bank, as well as other consolidated subsidiaries such as MSC, and other investments detailed in the consolidated summary schedule of investments following these footnotes. Included in level 3 equity investments are unregistered shares of common stock in a publicly-held company, as well as certain private equity positions in non-marketable securities.
The following tables provide a summary of changes in fair value of the Company’s level 3 assets and liabilities for the quarters and nine months ended September 30, 2017 and 2016.
June 30, 2017
Gains (losses) included in earnings
Purchases, investments, and issuances
Sales, maturities, settlements, and distributions
Amounts related to held assets(1)
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June 30, 2016
December 31, 2015
Transfers in (out) (1)
Amounts related to held assets(2)
Significant Unobservable Inputs
ASC Topic 820 requires disclosure of quantitative information about the significant unobservable inputs used in the valuation of assets and liabilities classified as Level 3 within the fair value hierarchy. The tables below are not intended to be all-inclusive, but rather to provide information on significant unobservable inputs and valuation techniques used by the Company.
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The valuation techniques and significant unobservable inputs used in recurring Level 3 fair value measurements of assets and liabilities as of September 30, 2017 and December 31, 2016 were as follows.
Valuation Techniques
Unobservable Inputs
Medallion Loans
Commercial Loans – Mezzanine and Other
the borrower
Portfolio yields
Investment in Medallion Bank
Investment in Other Controlled Subsidiaries
Financial condition and
operating performance of the investee
Equity Investments
Investments Other Than Securities
Other Assets
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(14) INVESTMENTS OTHER THAN SECURITIES
The following table presents the Company’s investments other than securities as of September 30, 2017 and December 31, 2016.
Investment Type (Dollars in thousands)
City of Chicago Taxicab Medallions
City of Chicago Taxicab Medallions (handicap accessible)
Total Investments Other Than Securities
(15) SUBSEQUENT EVENTS
We have evaluated subsequent events that have occurred through the date of financial statement issuance.
In October 2017, a term loan with a maturity date of October 31, 2017 was extended until November 1, 2018.
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Medallion Financial Corp.
Consolidated Summary Schedule of Investments
(Dollars in
thousands)
ObligorName/Interest RateRange
New York
Various New York && ##
Chicago
Various Chicago && ##
Newark && ##
Various Newark && ##
Boston && ##
Cambridge && ##
Various Other && ##
Total medallion loans ($219,977 pledged as collateral under borrowing arrangements)
Commercial Loans
Secured mezzanine (18% Minnesota, 14% North Carolina, 9% Oklahoma, 8% Ohio, 7% Texas, 7% Delaware 6% California, 5% Oregon, 5% Kansas, 5% North Dakota, 4% Pennsylvania, 4% Colorado, and 8% all other states) (2)
Manufacturing (37% of the total)
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Professional, Scientific, and Technical Services (20% of the total)
Arts, Entertainment, and Recreation (11% of the total)
Information (10% of the total)
Wholesale Trade (6% of the total)
Mining, Quarrying, and Oil and Gas Extraction (5% of the total)
Transportation and Warehousing (5% of the total)
Administrative and Support Services (4% of the total)
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(Dollars inthousands)
Construction (2% of the total)
Accommodation and Food Services (0% of the total)
Retail Trade (0% of the total)
Total secured mezzanine(2)
Other secured commercial (53% New York, 42% New Jersey and 5% all other states)
Retail Trade (81% of the total)
Accommodation and Food Services (14% of the total)
Transportation and Warehousing (3% of the total)
Real Estate and Rental and Leasing (2% of the total)
Total Other Commercial Loans(2)
Total commercial loans(2)
Commercial Banking
NASCAR Race Team
Art Dealer
Loan Servicing
Professional Sports Team
Media
Investment in Medallion Bank and other controlled subsidiaries, net
Commercial Finance
Employee Leasing Services
Weather Forecasting Services
Hand Tool Manufacturer
Services related to advertising
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Obligor Name/Interest RateRange
SecurityType (allrestrictedunlessotherwisenoted)
Envirnomental Consulting Services
Paper Tapes Manufacturer
Stuffed Toy Manufacturer
Baby Sleep Products
Manufacture Space Heaters, etc.
IT Services
Engineering Design Service
Hobbyists’ Supplies Merch. Wholesale
Sheet metal manufacturer
Manufacturer of industrial filters
Distributor & service provider of car wash equipment and chemical solutions
Distributor of specialty sand products
Design, assemble, distribute forensic supplies
Various Other #
Equity investments, net
Investment securities
Investment securities, net
Net Investments ($219,977 pledged as collateral under borrowing arrangements) (3)
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Medallion Financial Corp
CONSOLIDATED SCHEDULE OF INVESTMENTS IN AND ADVANCES TO AFFILIATES
As of and for the nine months ended September 30, 2017
Name of issuer and title
of issue (Dollars in
Number of shares
(all restricted unless otherwise noted)
Medallion Bank – common stock
Medallion Motorsports, LLC – membership interest (2)
Medallion Fine Art, Inc. – common stock (3)
LAX Group LLC – membership interest
Medallion Servicing Corp. – common stock
Medallion Taxi Media, Inc. – common stock
Total investments in Medallion Bank and other controlled subsidiaries
RPAC Racing LLC (2)
Stride Tool Holdings LLC (4) – membership interest
Northern Technologies LLC – membership interest (5)
ADSCO Holdco LLC – membership interest (6)
SWDP Acquisition Co LLC. (7)
Appliance Recycling Centers of America Inc. – common stock
Filter Holdings INC. (8)
Third Century JRT, Inc. (9)
Total equity investments in affiliates
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(4) The Company has a loan due from Stride Tool Holding LLC in the amount of $4,185as of September 30, 2017, and on which $160 and $470 of interest income was earned during the quarter and nine months ended September 30, 2017.
(5) The Company has a loan due from Northern Technologies LLC in the amount of $3,660 as if September 30, 2017, on which $121 and $356 of interest income was earned during the quarter and nine months ended September 30, 2017.
(6) The Company has a loan due from ADSCO Holdco LLC in the amount of $ 3,669as of September 30, 2017, and on which $120 and $355 of interest income was earned during the quarter and nine months ended September 30, 2017.
(7) The Company has a loan due from SWDP Acquisition Co LLC in the amount of $5,000 as if September 30, 2017, on which $179 and $344 of interest income was earned during the quarter and nine months ended September 30, 2017.
(8) The Company has a loan due from Filter Holdings INC in the amount of $1,250 as if September 30, 2017, on which $45 and $72 of interest income was earned during the quarter and nine months ended September 30, 2017.
(9) The Company has a loan due from JR Thompson Company LLC, an affiliate of Third Century JRT, Inc., in the amount of $1,319 as of September 30, 2017, on which $50 and $160 of interest income was earned during the quarter and nine months ended September 30, 2017.
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The table below provides a recap of the changes in the investment in the respective issuers for the 2017 quarters.
Name of Issuer
Title of Issue
Value as of 12/31/16
Gross additions / investments
Gross reductions / distributions
Net equity in profit and loss, and unrealized appreciation and (depreciation)
Value as of 3/31/17
Value as of 6/30/17
Other adjustments
Value as of 9/30/17
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(1) The Company has a loan due from Medallion Fine Art, Inc. in the amount of $1,167 as of September 30, 2017, $0 of which was advanced during 2017, and for which $2,165 was repaid.
(2) In addition to the equity ownership, the Company and a controlled subsidiary of the Company have three loans due from RPAC Racing LLC, an affiliate of Medallion Motorsports, LLC, in the amount of $8,645, $56 of which was advanced during 2017.
(3) The Company has a loan due from J. R. Thompson Company, LLC, an affiliate of Third Century JRT, Inc in the amount of $1,319 as of September 30, 2017, $306 of which was repaid during 2017.
(4) The Company has a loan due from Northern Technologies LLC in the amount of $3,660 as of September 30, 2017, $127 of which was advanced during 2017.
(5) The Company has a loan due from Stride Tool Holdings LLC in the amount of $4,185 as of September 30, 2017, $94 of which was advanced during 2017.
(6) The Company has a loan due from ADSCO Holdco LLC in the amount of $3,669 as of September 30, 2017, $56 of which was advanced during 2017.
(7) The Company has a loan due from Filter Holdings Inc. in the amount of $1,250 as of September 30, 2017, all of which was advanced during 2017.
(8) The Company has a loan due from SWDP Acquisition Co LLC in the amount of $5,000 as of September 30, 2017, all of which was advanced during 2017.
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Obligor
Name/Interest Rate
Range
Total medallion loans ($231,494 pledged as collateral under borrowing arrangements)
Secured mezzanine (22% Minnesota, 12% Ohio, 10% Oklahoma, 8% Texas, 7% Delaware, 7% Pennsylvania, 7% North Carolina, 5% Kansas, 5% North Dakota, 4% Massachusetts, 4% Colorado, and 9% all other states) (2)
Manufacturing (44% of the total)
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+
Professional, Scientific, and Technical Services (21% of the total)
Information (12% of the total)
Arts, Entertainment, and Recreation (7% of the total)
Administrative and Support Services (5% of the total)
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Wholesale Trade (4% of the total)
Other secured commercial (46% New York, 38% North Carolina, 14% New Jersey and 2% all other states)
Retail Trade (54% of the total)
Arts, Entertainment, and Recreation (38% of the total)
Accommodation and Food Services (6% of the total)
Transportation and Warehousing (1% of the total)
Real Estate and Rental and Leasing (1% of the total)
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Security
Type (all
restricted
unless
otherwise
noted)
Investment Castings
Machine Shop
Net Investments ($231,494 pledged as collateral under borrowing arrangements) (3)
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CONSOLIDATED SCHEDULE OF INVESTMENTS IN AND ADVANCES TO AFFIILIATES
As of and for the year ended December 31, 2016
Name of issuer and title of issue
Number of shares (all restricted unless
otherwise noted)
Medallion Motorsports, LLC – membership interest (3)
Medallion Fine Art, Inc. – common stock (2)
RPAC Racing LLC (3)
ADSCO Holdco LLC (5)
Northern Technologies LLC – membership interest (6)
Micro Group, Inc. (7)
Third Century JRT, Inc. (8)
WRWP, LLC – membership interest (9)
Production Services Associates LLC (10)
Total equity investments in afiliates
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The table below provides a recap of the changes in the investment in the respective issuers for the year ended December 31, 2016.
Value as of 12/31/15
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GENERAL
We are a specialty finance company that has historically had a leading position in originating, acquiring, and servicing loans that finance taxicab medallions and various types of commercial businesses. Recently, our strategic growth has been through a wholly-owned portfolio company of ours, Medallion Bank, which originates consumer loans for the purchase of recreational vehicles, boats, motorcycles, and trailers, and to finance small-scale home improvements.
Since Medallion Bank acquired a consumer loan portfolio and began originating consumer loans in 2004, it has increased its consumer loan portfolio at a compound annual growth rate of 18%. Since 1996, the year in which we became a public company, we have increased our taxicab medallion loan portfolio at a compound annual growth rate of 2%, and our commercial loan portfolio at a compound annual growth rate of 3% (6% and 3% on a managed basis when combined with Medallion Bank). In January 2017, we announced our plans to transform our overall strategy. We are transitioning away from medallion lending and placing our strategic focus on our growing consumer finance portfolio. Total assets under our management and the management of our unconsolidated wholly-owned subsidiaries, which includes our managed net investment portfolio, as well as assets serviced for third party investors, were $1,646,000,000 as of September 30, 2017, and $1,632,000,000 and $1,634,000,000 as of December 31, 2016 and September 30, 2016, and have grown at a compound annual growth rate of 10% from $215,000,000 at the end of 1996.
Our loan-related earnings depend primarily on our level of net interest income. Net interest income is the difference between the total yield on our loan portfolio and the average cost of borrowed funds. We fund our operations through a wide variety of interest-bearing sources, such as revolving bank facilities, bank certificates of deposit issued to customers, debentures issued to and guaranteed by the SBA, and bank term debt. Net interest income fluctuates with changes in the yield on our loan portfolio and changes in the cost of borrowed funds, as well as changes in the amount of interest-bearing assets and interest-bearing liabilities held by us. Net interest income is also affected by economic, regulatory, and competitive factors that influence interest rates, loan demand, and the availability of funding to finance our lending activities. We, like other financial institutions, are subject to interest rate risk to the degree that our interest-earning assets reprice on a different basis than our interest-bearing liabilities.
We also provide debt, mezzanine, and equity investment capital to companies in a variety of industries, consistent with our investment objectives. These investments may be venture capital style investments which may not be fully collateralized. Medallion Capital’s investments are typically in the form of secured debt instruments with fixed interest rates accompanied by an equity stake or warrants to purchase an equity interest for a nominal exercise price (such warrants are included in equity investments on the consolidated balance sheets). Interest income is earned on the debt instruments.
We are a closed-end, non-diversified management investment company, organized as a Delaware corporation, under the 1940 Act. We have elected to be treated as a BDC under the 1940 Act. During our tax year ended December 31, 2016, we did not qualify as a RIC under Subchapter M of the Internal Revenue Code of 1986, as amended, or the Code, and therefore we became subject to taxation as a corporation under Subchapter C of the Code. We had in previous years qualified and elected to be treated for federal income tax purposes as a RIC. As a RIC, we generally did not have to pay corporate-level federal income taxes on any net ordinary income or capital gains that we distributed to our shareholders as dividends, if we met certainsource-of-income and asset diversification requirements. Medallion Bank is not a RIC and must pay corporate-level US federal and state income taxes. See Note 5 for more information.
Our wholly-owned portfolio company, Medallion Bank, is a bank regulated by the FDIC and the Utah Department of Financial Institutions which originates consumer loans, raises deposits, and conducts other banking activities. Medallion Bank generally provides us with our lowest cost of funds which it raises through bank certificates of deposit. To take advantage of this low cost of funds, historically we have referred a portion of our taxicab medallion and commercial loans to Medallion Bank, who originated these loans, and have been serviced by MSC. However, at this time Medallion Bank is not originating any new taxi medallion loans and is working with MSC to service its existing portfolio. The FDIC restricts the amount of taxicab medallion loans that Medallion Bank may finance to three times Tier 1 capital, or $507,198,000 as of September 30, 2017. MSC earns referral and servicing fees for these activities. As a non-investment company, Medallion Bank is not consolidated with the Company.
Realized gains or losses on investments are recognized when the investments are sold or written off. The realized gains or losses represent the difference between the proceeds received from the disposition of portfolio assets, if any, and the cost of such portfolio assets. In addition, changes in unrealized appreciation or depreciation on investments are recorded and represent the net change in the estimated fair values of the portfolio assets at the end of the period as compared with their estimated fair values at the beginning of the period. Generally, realized gains (losses) on investments and changes in unrealized appreciation (depreciation) on investments are inversely related. When an appreciated asset is sold to realize a gain, a decrease in the previously recorded unrealized appreciation occurs. Conversely, when a loss previously recorded as unrealized depreciation is realized by the sale or other disposition of a depreciated portfolio asset, the reclassification of the loss from unrealized to realized causes a decrease in net unrealized depreciation and an increase in realized loss.
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Our investment in Medallion Bank, as a wholly owned portfolio investment, is also subject to quarterly assessments of fair value. We conduct a thorough valuation analysis as described previously, and determine whether any factors give rise to a valuation different than recorded book value, including various regulatory restrictions that were established at Medallion Bank’s inception, by the FDIC and State of Utah, and also by additional marketplace restrictions, such as the ability to transfer industrial bank charters. Because of these restrictions and other factors, our Board of Directors had previously determined that Medallion Bank had little value beyond its recorded book value. As a result of this valuation process, we had previously used Medallion Bank’s actual results of operations as the best estimate of changes in fair value, and recorded the results as a component of unrealized appreciation (depreciation) on investments. In the second quarter of 2015, we first became aware of external interest in Medallion Bank and its portfolio’s assets at values in excess of their book value. Expression of interest in Medallion Bank from both investment bankers and interested parties has continued through 2016 and 2017. We incorporated these new factors in the Medallion Bank’s fair value analysis and the Board of Directors determined that Medallion Bank had a fair value in excess of book value. In addition, in the 2016 third quarter there was a court ruling involving a marketplace lender that we believe heightens the interest of marketplace lenders to acquire or merge with Utah industrial banks. We also engaged a valuation specialist to assist the Board of Directors in its determination of Medallion Bank’s fair value, and this appreciation of $15,500,000 was thereby recorded in 2015, and additional appreciation of $128,918,000 was recorded in 2016, and $563,000 was recorded in 2017. See Note 3 for additional information about Medallion Bank.
Trends in Investment Portfolio
Our investment income is driven by the principal amount of and yields on our investment portfolio. To identify trends in the balances and yields, the following table illustrates our investments at fair value, grouped by medallion loans, commercial loans, equity investments, and investment securities, and also presents the portfolio information for Medallion Bank, at the dates indicated.
Boston
Newark
Cambridge
Total medallion loans
Deferred loan acquisition costs
Unrealized depreciation on loans
Net medallion loans
Deferred loan acquisition income
Net commercial loans
Unrealized appreciation on subsidiary investments
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Unrealized appreciation on equities
Net equity investments
Unrealized depreciation on investment securities
Net investment securities
Investments at cost (2)
Unrealized appreciation on controlled subsidiaries and equity investments
Net investments
Medallion Bank investments
Consumer loans
Medallion Bank investments at cost (2)
Premiums paid on purchased securities
Medallion Bank net investments
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Investment Activity
The following table sets forth the components of investment activity in the investment portfolio for the periods indicated.
Net investments at beginning of period
Investments originated (1)
Repayments of investments (1)
Net increase in unrealized appreciation (depreciation) (2)
Accretion of net origination fees
Net increase (decrease) in investments
Net investments at end of period
PORTFOLIO SUMMARY
Total Portfolio Yield
The weighted average yield (which is calculated by dividing the aggregate yield of each investment in the portfolio by the aggregate portfolio balance and does not include expenses and sales load for any offering) of the total portfolio at September 30, 2017 was 4.70% (6.40% for the loan portfolio), a decrease of 24 basis points from 4.94% at December 31, 2016, and a decrease of 66 basis points from 5.36% at September 30, 2016. The decreased yield in 2017 was primarily attributable to the decreased yield in our investment in Medallion Bank and other controlled subsidiaries. The weighted average yield of the total managed portfolio at September 30, 2017 was 10.41% (10.63% for the loan portfolio), an increase of 92 basis points from 9.49% at December 31, 2016, and an increase of 103 basis points from 9.38% at September 30, 2016. The increased yield of the total managed portfolio was mainly due to the higher proportion of consumer loans to the total portfolio as well as an increase in the yield on Medallion loans.
Medallion Loan Portfolio
Our medallion loans comprised 36% of the net portfolio of $621,185,000 at September 30, 2017, compared to 41% of the net portfolio of $652,278,000 at December 31, 2016, and 49% of $585,628,000 at September 30, 2016. Our managed medallion loans of $430,048,000 comprised 28% of the net managed portfolio of $1,507,526,000 at September 30, 2017, compared to 35% of the net managed portfolio of $1,517,592,000 at December 31, 2016, and 40% of $1,450,192,000 at September 30, 2016. The medallion loan portfolio decreased by $42,235,000 or 16% in 2017 (a decrease of $98,595,000 or 19% on a managed basis), primarily reflecting increased realized and unrealized losses and net amortization of loan principal, especially in the New York and Chicago markets. Total medallion loans serviced for third parties were $26,456,000, $24,796,000, and $24,889,000 at September 30, 2017, December 31, 2016, and September 30, 2016.
The weighted average yield of the medallion loan portfolio at September 30, 2017 was 4.44%, an increase of 43 basis points from 4.01% at December 31, 2016, and an increase of 37 basis points from 4.07% at September 30, 2016. The weighted average yield of the managed medallion loan portfolio at September 30, 2017 was 4.38%, an increase of 50 basis points from 3.88% at December 31, 2016, and an increase of 43 basis points from 3.95% at September 30, 2016. The fluctuation in yield primarily reflected the repricing of the existing portfolio to current market interest rates. At September 30, 2017, 32% of the medallion loan portfolio represented loans outside New York, compared to 31% at December 31, 2016 and September 30, 2016. At September 30, 2017, 22% of the managed medallion loan portfolio represented loans outside New York, compared to 24% at December 31, 2016 and 26% at September 30, 2016.
Commercial Loan Portfolio
Our commercial loans represented 13%, 13%, and 14% of the net investment portfolio as of September 30, 2017, December 31, 2016, and September 30, 2016, and were 6%, 6%, and 6% on a managed basis. Commercial loans decreased by $875,000 or 1% during 2017 (decreased $1,690,000 or 2% on a managed basis). The decreases primarily reflected Medallion Fine Art loan repayments offset by an increase in mezzanine lending. Net commercial loans serviced for third parties were $1,307,000 at September 30, 2017, $1,644,000 at December 31, 2016, and $1,563,000 at September 30, 2016.
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The weighted average yield of the commercial loan portfolio at September 30, 2017 was 12.91%, a decrease of 14 basis points from 13.05% at December 31, 2016 and a decrease of 16 basis points from 13.07% at September 30, 2016. The weighted average yield of the managed commercial loan portfolio at September 30, 2017 was 12.69%, a decrease of 7 basis points from 12.76% at December 31, 2016, and a decrease of 5 basis points from 12.74% at September 30, 2016. The change primarily reflected changes in the portfolio mix and higher yields on the mezzanine portfolio. At September 30, 2017, variable-rate loans represented approximately 5% of the commercial portfolio, compared to 7% and 5% at December 31, 2016 and September 30, 2016, and were 5%, 7%, and 5% on a managed basis.
Consumer Loan Portfolio
Our managed consumer loans, all of which are held in the portfolio managed by Medallion Bank, represented 52%, 46%, and 47% of the managed net investment portfolio as of September 30, 2017, December 31, 2016, and September 30, 2016. Medallion Bank originates fixed rate consumer loans secured by recreational vehicles, boats, motorcycles, trailers and home improvements located in all 50 states. The portfolio is serviced by a third party.
The consumer loans increased by $85,822,000 or 12% during 2017, despite the sale of $94,000,000 of consumer loans to a third party investor in the 2017 first quarter.
The weighted average gross yield of the managed consumer loan portfolio was 14.47% at September 30, 2017, an increase of 20 basis points from 14.27% at December 31, 2016, and an increase of 3 basis points from 14.44% at September 30, 2016. The increases in yield primarily reflected the sales in the 2017 first quarter of $94,000,000 of mostly lower-yielding home improvement loans. Adjustable rate loans were 8%, 12%, and 13% of the managed consumer portfolio at September 30, 2017, December 31, 2016, and September 30, 2016, reflecting Medallion Bank no longer offering variable rate loan products.
Delinquency and Loan Loss Experience
We generally follow a practice of discontinuing the accrual of interest income on our loans that are in arrears as to payments for a period of 90 days or more. We deliver a default notice and begin foreclosure and liquidation proceedings when management determines that pursuit of these remedies is the most appropriate course of action under the circumstances. A loan is considered to be delinquent if the borrower fails to make a payment on time; however, during the course of discussion on delinquent status, we may agree to modify the payment terms of the loan with a borrower that cannot make payments in accordance with the original loan agreement. For loan modifications, the loan will only be returned to accrual status if all past due interest and principal payments are brought fully current. For credit that is collateral based, we evaluate the anticipated net residual value we would receive upon foreclosure of such loans, if necessary. There can be no assurance, however, that the collateral securing these loans will be adequate in the event of foreclosure. For credit that is cash flow-based, we assess our collateral position, and evaluate most of these relationships as ongoing businesses, expecting to locate and install a new operator to run the business and reduce the debt.
For the consumer loan portfolio, the process to repossess the collateral is started at 60 days past due. If the collateral is not located and the account reaches 120 days delinquent, the account is charged off to realized losses. If the collateral is repossessed, a realized loss is recorded to write the collateral down to its net realizable value, and the collateral is sent to auction. When the collateral is sold, the net auction proceeds are applied to the account, and any remaining balance is written off as a realized loss, and any excess proceeds are recorded as a realized gain. Proceeds collected on charged off accounts are recorded as realized gains. All collection, repossession, and recovery efforts are handled on behalf of Medallion Bank by the servicer.
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The following table shows the trend in loans 90 days or more past due as of the dates indicated.
Total loans 90 days or more past due
Total Medallion Bank loans
Total managed loans 90 days or more past due
A third party finance company sold various participations in asset based loans to Medallion Business Credit and Medallion Bank. In April 2013, the aggregate balance of the participations was approximately $13.8 million, $12.9 million of which were held by Medallion Bank. That amount was divided between seven separate borrowers operating in a variety of industries. In April 2013, the third party finance company became the subject of an involuntary bankruptcy petition filed by its bank lenders. Among other things, the bank lenders alleged that the third party finance company fraudulently misrepresented its borrowing availability under its credit facility with the bank lenders and are seeking the third party finance company’s liquidation. In May 2013, the bankruptcy court presiding over the third party finance company’s case entered an order converting the involuntary chapter 7 case to a chapter 11 case. We and Medallion Bank have placed these loans on nonaccrual, and reversed interest income. In addition, we have established valuation allowances against the outstanding balances. On May 31, 2013, we commenced an adverse proceeding against the third party finance company and the bank lenders seeking declaratory judgment that our loan participations are true participations and not subject to the bankruptcy estate or to the bank lender’s security interest in the third party finance company’s assets. The third party finance company and bank lenders are contesting our position. In April 2014, we and Medallion Bank received a decision from the court granting summary judgment in our favor with respect to the issue of whether our loan participations are true participations. In March 2015, we and Medallion Bank received a decision from the court finding that the bank lenders generally held a first lien on our and Medallion Bank’s loan participations subject to, among other things, defenses still pending prosecution by the parties and adjudication by the court. We and Medallion Bank are appealing the decision. The remaining issues are still being litigated. Although we believe the claims raised by the third party finance company and the bank lenders are without merit and will vigorously defend against them, we cannot at this time predict the outcome of this litigation or determine our potential exposure. At September 30, 2017, five of the seven secured borrowers had refinanced their loans in full with third parties, and the related proceeds are held in escrow pending resolution of the bankruptcy proceedings. One loan was charged off in September 2014. In September 2015, one loan was sold at a discount to a third party, and the related proceeds are held in escrow pending resolution of the bankruptcy proceedings. The balances related to the paid off loans have been reclassified to other assets on the consolidated balance sheet. The table below summarizes these receivables and their status with the Company and Medallion Bank.
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The recent increases in medallion delinquencies reflected our borrowers experiencing declining cash flows due to competitive internet ride hailing services and decreases in medallion values putting stress on certain of our borrowers, all of whom we continue to work with. We have vigorously pursued strategies to offset these declines which have included adding personnel to the collection staff, receiving principal reductions as loans renew, and requiring additional collateral so as to offer temporary solutions until cash flows improve. Additionally, we have had some success in assisting delinquent customers in selling their medallions to new owners putting a reasonable amount of cash equity into the sales so as to reduce our exposure on the collateral. This in turn has improved the overall cash flow to debt service ratio. Medallion Bank delinquencies have declined during 2017 due to an increase in medallion loan charge-offs during the quarter.
We monitor delinquent loans for possible exposure to loss by analyzing various factors, including the value of the collateral securing the loan and the borrower’s prior payment history. Under the 1940 Act, our loan portfolio must be recorded at fair value or “marked-to-market.” Unlike other lending institutions, we are not permitted to establish reserves for loan losses. Instead, the valuation of our portfolio is adjusted quarterly to reflect our estimate of the current realizable value of our loan portfolio. Since no ready market exists for this portfolio, fair value is subject to the good faith determination of our Board of Directors. Because of the subjectivity of these estimates, there can be no assurance that in the event of a foreclosure or the sale of portfolio loans we would be able to recover the amounts reflected on our balance sheet.
In determining the value of our portfolio, the Board of Directors may take into consideration various factors such as the financial condition of the borrower and the adequacy of the collateral. For example, in a period of sustained increases in market interest rates, the Board of Directors could decrease its valuation of the portfolio if the portfolio consists primarily of long-term, fixed-rate loans. Our valuation procedures are designed to generate values that approximate that which would have been established by market forces, and are therefore subject to uncertainties and variations from reported results. Based upon these factors, net unrealized appreciation or depreciation on investments is determined, based on the fluctuations of our estimate of the current realizable value of our portfolio from our cost basis.
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The following tables set forth the pre-tax changes in our unrealized appreciation (depreciation) on investments, for the 2017 and 2016 quarters shown below.
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Reversal of unrealized appreciation(depreciation) related to realized
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The following table presents credit-related information for the investment portfolios as of the dates shown.
Total loans
Investments in Medallion Bank and other controlled subsidiaries
Equity investments (1)
Net investments at Medallion Bank and other controlled subsidiaries
Managed net investments
Unrealized appreciation (depreciation) on investments
Total unrealized appreciation on investments
Net unrealized depreciation on investments at Medallion Bank and other controlled subsidiaries
Managed total unrealized appreciation (depreciation) on investments
Unrealized appreciation (depreciation) as a % of balances outstanding (2)
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The following table presents the gain/loss experience on the investment portfolios for the three and nine months ended September 30, 2017 and 2016.
Realized gains (losses) on loans and equity investments
Total realized gains (losses) on loans and equity investments
Net realized gains (losses) on investments at Medallion Bank and other controlled subsidiaries
Total managed realized gains (losses) on loans and equity investments
Realized gains (losses) as a % of average balances outstanding
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Realized losses on investments other than securities and other assets
Investment in Medallion Bank and Other Controlled Subsidiaries
Investment in Medallion Bank and other controlled subsidiaries were 49%, 45%, and 36% of our total portfolio at September 30, 2017, December 31, 2016, and September 30, 2016. The portfolio company investments primarily represent the wholly-owned unconsolidated subsidiaries of ours, substantially all of which is represented by our investment in Medallion Bank. In addition, to facilitate maintenance of Medallion Bank’s capital ratio requirement and to provide the necessary capital for continued growth, we periodically make capital contributions to Medallion Bank including $3,000,000 in 2016. Separately, Medallion Bank declared dividends to us of $3,000,000 in 2016. See Note 3 of the consolidated financial statements for additional information about these investments.
Equity investments were 2% of our total portfolio at September 30, 2017, and were 1% at December 31, 2016 and September 30, 2016. Equity investments were less than 1%, 1%, and 1% of our total managed portfolio at September 30, 2017, December 31, 2016, and September 30, 2016. Equity investments are comprised of common stock, limited partnership interests, preferred stock, and warrants.
Investment Securities
Investment securities were 0% of our total portfolio at September 30, 2017, December 31, 2016, and September 30, 2016. Investment securities were 3%, 2%, and 3% of our total managed portfolio at September 30, 2017, December 31, 2016, and September 30, 2016. The investment securities are primarily United States Treasury bills and adjustable-rate mortgage-backed securities purchased by us and Medallion Bank to better utilize required cash liquidity.
Trend in Interest Expense
Our interest expense is driven by the interest rates payable on our short-term credit facilities with banks, bank certificates of deposit, fixed-rate, long-term debentures issued to the SBA, and other short-term notes payable. We established a medallion lending
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relationship with DZ Bank in December 2008 that provided for growth in the portfolio at generally lower rates than under prior facilities. In addition, Medallion Bank began raising brokered bank certificates of deposit during 2004, which were at our lowest borrowing costs. As a result of Medallion Bank raising funds through certificates of deposit as previously noted, we were able to transfer certain of our medallion loans and related assets to Medallion Bank allowing us and our subsidiaries to use cash generated through these transactions to retire debt with higher interest rates. In addition, Medallion Bank is able to bid on these deposits at a wide variety of maturity levels which allows for improved interest rate management strategies.
Our cost of funds is primarily driven by the rates paid on our various debt instruments and their relative mix, and changes in the levels of average borrowings outstanding. See Note 4 to the consolidated financial statements for details on the terms of all outstanding debt. Our debentures issued to the SBA typically have terms of ten years.
We measure our borrowing costs as our aggregate interest expense for all of our interest-bearing liabilities divided by the average amount of such liabilities outstanding during the period. The following table shows the average borrowings and related borrowing costs for the three and nine months ended September 30, 2017 and 2016. Our average balances for the nine months ended September 30, 2017 decreased reflecting the fluctuation in the investment portfolio and Medallion Bank’s average balances decreased, reflecting the sale of $94,000,000 of consumer loans to a third party, offset by strong growth in the consumer loan portfolio. The increase in borrowing costs primarily reflected the repricing of term borrowings, and Medallion Bank’s increased reflecting a lengthening of their maturity profile.
SBA debentures
Medallion Bank borrowings
Total managed borrowings
Margin loans
We will continue to seek SBA funding through Medallion Capital to the extent it offers attractive rates. SBA financing subjects its recipients to limits on the amount of secured bank debt they may incur. We use SBA funding to fund loans that qualify under the SBIA and SBA regulations. We believe that financing operations primarily with short-term floating rate secured bank debt has generally decreased our interest expense, but has also increased our exposure to the risk of increases in market interest rates, which we mitigate with certain interest rate strategies. At September 30, 2017 and 2016, short-term adjustable rate debt constituted 59% of total debt, and was 15% and 17% on a fully managed basis including the borrowings of Medallion Bank.
Factors Affecting Net Assets
Factors that affect our net assets include net realized gain or loss on investments and change in net unrealized appreciation or depreciation on investments. Net realized gain or loss on investments is the difference between the proceeds derived upon sale or foreclosure of a loan or an equity investment and the cost basis of such loan or equity investment. Change in net unrealized appreciation or depreciation on investments is the amount, if any, by which our estimate of the fair value of our investment portfolio is above or below the previously established fair value or the cost basis of the portfolio. Under the 1940 Act our loan portfolio and other investments must be recorded at fair value.
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Unlike certain lending institutions, we are not permitted to establish reserves for loan losses, but adjust quarterly the valuation of the investment portfolio to reflect our estimate of the current value of the total investment portfolio. Since no ready market exists for our investments, fair value is subject to our Board of Directors’ good faith determination. In determining such fair value, our Board of Directors considers factors such as the financial condition of our borrowers and the adequacy of their collateral. Any change in the fair value of portfolio investments or other investments as determined by our Board of Directors is reflected in net unrealized depreciation or appreciation on investments and affects net increase in net assets resulting from operations, but has no impact on net investment income or distributable income.
Our investment in Medallion Bank, as a wholly-owned portfolio investment, is also subject to quarterly assessments of fair value. We conduct a thorough valuation analysis as described previously, and also receive an opinion regarding the valuation from an independent third party to assist the Board of Directors in its determination of the fair value of Medallion Bank on at least an annual basis. Our analysis includes factors such as various regulatory restrictions that were established at Medallion Bank’s inception, by the FDIC and State of Utah, and also by additional regulatory restrictions, such as the prior moratorium imposed by the Dodd-Frank Act on the acquisition of control of an industrial bank by a “commercial firm” (a company whose gross revenues are primarily derived from nonfinancial activities) which expired in July 2013 and the lack of any new charter issuances since the moratorium’s expiration. Because of these restrictions and other factors, our Board of Directors had previously determined that Medallion Bank had little value beyond its recorded book value. As a result of this valuation process, we had previously used Medallion Bank’s actual results of operations as the best estimate of changes in fair value, and recorded the results as a component of unrealized appreciation (depreciation) on investments. In the second quarter of 2015, we first became aware of external interest in Medallion Bank and its portfolio’s assets at values in excess of their book value. Expression of interest in Medallion Bank from both investment bankers and interested parties has continued through 2016 and 2017. We incorporated these new factors in the Medallion Bank’s fair value analysis and the Board of Directors determined that Medallion Bank had a fair value in excess of book value. In addition, in the 2016 third quarter there was a court ruling involving a marketplace lender that we believe heightens the interest of marketplace lenders to acquire or merge with Utah industrial banks. We also engaged a valuation specialist to assist the Board of Directors in its determination of Medallion Bank’s fair value, and this appreciation of $15,500,000 was thereby recorded in 2015, and additional appreciation of $128,918,000 was recorded in 2016, and $563,000 was recorded in 2017. See Note 3 for additional information about Medallion Bank.
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SELECTED FINANCIAL DATA
Summary Consolidated Financial Data
You should read the consolidated financial information below with the Consolidated Financial Statements and Notes thereto for the three and nine months ended September 30, 2017 and 2016.
Statement of operations
Net investment loss before income taxes
Net change in unrealized appreciation on Medallion Bank and other controlled subsidiaries (1)
Net change in unrealized depreciation on investments (1)
Net increase in net assets resulting from operations
Per share data
Net change in unrealized appreciation (depreciation) on investments (1)
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Total funds borrowed
Total shareholders’ equity
Managed balance sheet data(2)
Selected financial ratios and other data
Return on average assets (ROA)(3)
Net investment loss after taxes
Return on average equity (ROE) (4)
Net increase(decrease) in net assets resulting from operations
Weighted average yield
Weighted average cost of funds
Net interest margin (5)
Noninterest income ratio (6)
Total expense ratio (7)
Operating expense ratio (8)
Investments to assets (9)
Equity to assets (10)
Debt to equity (11)
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Consolidated Results of Operations
2017 Third Quarter and Nine Months compared to the 2016 periods
Net increase (decrease) in net assets resulting from operations was $619,000 or $0.03 per diluted common share and ($3,067,000) or ($0.13) in the 2017 third quarter and nine months, down $4,424,000 or 88% and $19,525,000 or 119% from $5,043,000 or $0.21 per share and $16,458,000 or $0.68 in the 2016 third quarter and nine months, primarily reflecting higher unrealized depreciation on the investment portfolio, lower interest income from the medallion loan portfolio, lower dividend income from controlled subsidiaries, higher interest expenses and lower realized gains, offset by lower operating expenses, and higher income tax benefits. Net investment loss after income taxes was ($2,490,000) or ($0.10) per share and ($4,218,000) or ($0.18) in the 2017 quarter and nine months, down $116,000 or 4% and $2,249,000 or 114% from ($2,606,000) or ($0.11) per share and ($1,969,000) or ($0.08) in the 2016 quarter and nine months.
Investment income was $5,567,000 and $13,604,000 in the 2017 third quarter and nine months, up $298,000 or 6% and down $6,487,000 or 32% from $5,269,000 and $20,091,000 in the year ago periods. This included $1,845,000 and $4,691,000 of interest reversals related to nonaccrual loans in the 2017 quarter and nine months, compared to $1,220,000 and $2,230,000 in the 2016 quarter and nine months. This also included $1,256,000 in dividends from controlled subsidiaries in the 2017 quarter and nine months, compared to $0 and $3,000,000 in the comparable 2016 periods. The yield on the investment portfolio was 3.55% in the 2017 quarter, consistent with 2016, and was 2.88% in the 2017 nine months, down 35% from 4.45% in the 2016 nine months. Excluding the dividends in prior year, the 2017 third quarter and nine month yields were unchanged and down 24% from 3.55% and 3.79% in the 2016 quarter and nine months, reflecting the increases in the level of loans on nonaccrual and interest applied to principal. Average investments outstanding were up 5% to $622,908,000 in the 2017 quarter and were up 5% to $631,832,000 in the nine months, from $591,257,000 and $602,399,000 in the year ago periods, primarily reflecting portfolio growth.
Medallion loans were $224,580,000 at quarter end, down $63,677,000 or 22% from $288,257,000 a year ago, representing 36% of the investment portfolio compared to 49% a year ago, and were yielding 4.44% compared to 4.22% a year ago, an increase of 5%, reflecting portfolio shrinkage and the repricing of the existing portfolio to higher current market interest rates. The decrease in outstandings was primarily concentrated in the New York market, although all markets declined, and reflected increased realized and unrealized losses and net amortization of loan principal. The managed medallion loan portfolio, which includes loans at Medallion Bank and those serviced for third parties, was $456,504,000 at quarter end, down $155,511,000 or 25% from $612,015,000 a year ago, reflecting the above. The commercial loan portfolio was $82,760,000 at quarter end, compared to $81,110,000 a year ago, an increase of $1,650,000 or 2%, and represented 13% of the investment portfolio compared to 14% a year ago. The increase reflects growth in the secured mezzanine portfolio. The net managed commercial loan portfolio, which includes loans at Medallion Bank and those serviced for or by third parties, was $85,817,000 at quarter end, up $195,000 or less than 1% from $85,622,000 a year ago. Investments in Medallion Bank and other controlled subsidiaries were $303,861,000 at quarter end, up $95,763,000 or 46% from $208,098,000 a year ago, primarily reflecting appreciation of Medallion Bank and to a lesser extent other portfolio company investments, and which represented 49% of the investment portfolio, compared to 36% a year ago, and which yielded 0.83% at quarter end, compared to 3.88% a year ago, primarily reflecting the reduced dividends from Medallion Bank offset by increased dividends from other controlled subsidiaries. See Notes 3 and 11 of the consolidated financial statements for additional information about Medallion Bank and the other controlled subsidiaries. Equity investments were $9,984,000 at quarter end, up $1,821,000 or 22% from $8,163,000 a year ago, primarily reflecting increased investments and represented 2% of the investment portfolio at quarter end, compared to 1% a year ago, and had a dividend yield of 0.00%, compared to 0.66% a year ago.
Interest expense was $3,543,000 and $10,285,000 in the 2017 quarter and nine months, up $170,000 or 5% and $1,012,000 or 11% from $3,373,000 and $9,273,000 in the 2016 periods. The increase in interest expense was primarily due to increased borrowing costs. The cost of borrowed funds was 4.25% and 4.09% in the 2017 quarter and nine months, compared to 3.69% and 3.17% in the year ago periods, an increase of 15% and 29%, reflecting the adjustable rate nature of much of our borrowings, and changes in our funding mix. Average debt outstanding was down 9% to $330,885,000 for the 2017 quarter, and was down 14% to $335,907,000 in the nine months, compared to $363,943,000 and $390,472,000 in the year ago periods, primarily reflecting decreased borrowings required to fund the contracting loan and investment securities portfolios. See page 65 for a table which shows average balances and cost of funds for our funding sources.
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Net interest income was $2,024,000 and $3,319,000 and the net interest margin was 1.29% and 0.70% for the 2017 third quarter and nine months, up $128,000 or 7% and down $7,499,000 or 69% from $1,896,000 and $10,818,000 a year ago, which represented net interest margins of 1.28% and 2.40% all reflecting the items discussed above.
Noninterest income, which is comprised of management fees, late charges, servicing fees, prepayment fees, and other miscellaneous income was $8,000 and $22,000 in the 2017 third quarter and nine months, down $96,000 or 92% and $143,000 or 87% from $104,000 and $165,000 a year ago, primarily reflecting lower servicing and other fees generated from the portfolio base at Medallion Bank.
Operating expenses were $3,676,000 and $9,583,000 in the 2017 third quarter and nine months, down $930,000 or 20% and $3,369,000 or 26% from $4,606,000 and $12,952,000 in the 2016 periods. Salaries and benefits expense was $2,224,000 and $5,086,000 in the third quarter and nine months, down $815,000 and $3,730,000 or 27% and 42% from $3,039,000 and $8,816,000 in 2016, primarily due to a reduction in bonus costs recorded in the current period. Professional fees were $567,000 and $1,875,000 in the quarter and nine months, down $8,000 or 1% and up $534,000 or 40% from $575,000 and $1,341,000 a year ago, primarily reflecting higher legal expenses for a variety of corporate and investment-related matters. Occupancy and other operating expense was $885,000 and $2,622,000 in the quarter and nine months, down $107,000 or 11% and down $173,000 or 6% from $992,000 and $2,795,000 in the 2016 periods, primarily reflecting higher lease costs in the nine month period and offset by higher business development reimbursements from Medallion Bank in the current periods.
Total income tax benefit was $6,155,000 and $15,144,000 in the 2017 third quarter and nine months, compared to $0 and $0 in the year ago periods, and was comprised of two components, a $846,000 provision and $2,024,000 benefit related to the net investment loss in the 2017 third quarter and nine months, and benefits of $7,001,000 and $13,120,000 related to unrealized losses on investments. The tax benefit recorded in 2017 reflected the change in the Company’s tax status that was determined at the end of 2016. See Note 5 for more information.
Net change in unrealized appreciation on investments before tax was depreciation of $4,836,000 and $15,754,000 in the 2017 third quarter and nine months, compared to appreciation of $5,150,000 and $18,434,000 in the 2016 third quarter and nine months, a decrease in appreciation of $9,986,000 in the quarter and $34,188,000 in the nine months. Net change in unrealized appreciation other than the portion related to Medallion Bank and the other controlled subsidiaries, was depreciation of $6,871,000 and $26,843,000 in the 2017 quarter and nine months, compared to depreciation of $20,763,000 and $25,787,000 in the 2016 periods, resulting in decreased depreciation of $13,892,000 and increased depreciation of $1,056,000 in the 2017 quarter and nine months. Unrealized appreciation (depreciation) arises when we make valuation adjustments to the investment portfolio. When investments are sold or written off, any resulting realized gain (loss) is grossed up to reflect previously recorded unrealized components. As a result, movement between periods can appear distorted. The 2017 activity resulted from net appreciation on Medallion Bank and other controlled subsidiaries of $2,035,000 ($11,089,000 in the nine months) and by reversals of unrealized depreciation associated with fully depreciated loans which were charged off of $371,000 ($2,656,000 in the nine months), offset by net unrealized depreciation on equity investments, investment securities and loans of $6,955,000 ($27,122,000 of net depreciation in the nine months.) The 2016 activity resulted from net appreciation on Medallion Bank and other controlled subsidiaries of $25,913,000 ($44,221,000 in the nine months) and by reversals of unrealized depreciation associated with fully depreciated loans which were charged off of $173,000 ($3,063,000 in the nine months), partially offset by net depreciation on foreclosed property of $14,107,000 ($18,862,000 in the nine months), net unrealized depreciation on equity investments, investment securities and loans of $6,229,000 ($9,400,000 of net depreciation in the nine months).
Our net realized gains on investments were $944,000 and $3,785,000 in the 2017 quarter and nine months, compared to a gain of $2,499,000 and loss of $7,000 in the 2016 quarter and nine months, a decrease in realized gains of $1,555,000 in the quarter and an increase in realized gains of $3,792,000 in the nine months. The 2017 activity reflected $1,187,000 ($4,189,000 in the nine months) of other gains, offset by net realized losses and recoveries of $243,000 ($404,000 in the nine months).
Our net realized/unrealized losses on investments before tax were $3,892,000 and $11,969,000 in the 2017 quarter and nine months, compared to gains of $7,649,000 and $18,427,000 in the 2016 periods, a decrease of $11,541,000 or 151% in the quarter and $30,396,000 or 165% in the nine months, of net gains in the 2017 periods, reflecting the above.
ASSET/LIABILITY MANAGEMENT
Interest Rate Sensitivity
We, like other financial institutions, are subject to interest rate risk to the extent that our interest-earning assets (consisting of medallion, commercial, and consumer loans; and investment securities) reprice on a different basis over time in comparison to our interest-bearing liabilities (consisting primarily of credit facilities with banks and other lenders, bank certificates of deposit, and SBA debentures).
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Having interest-bearing liabilities that mature or reprice more frequently on average than assets may be beneficial in times of declining interest rates, although such an asset/liability structure may result in declining net earnings during periods of rising interest rates. Abrupt increases in market rates of interest may have an adverse impact on our earnings until we are able to originate new loans at the higher prevailing interest rates. Conversely, having interest-earning assets that mature or reprice more frequently on average than liabilities may be beneficial in times of rising interest rates, although this asset/liability structure may result in declining net earnings during periods of falling interest rates. This mismatch between maturities and interest rate sensitivities of our interest-earning assets and interest-bearing liabilities results in interest rate risk.
The effect of changes in interest rates is mitigated by regular turnover of the portfolio. Based on past experience, we anticipate that approximately 40% of the taxicab medallion portfolio will mature or be prepaid each year. We believe that the average life of our loan portfolio varies to some extent as a function of changes in interest rates. Borrowers are more likely to exercise prepayment rights in a decreasing interest rate environment because the interest rate payable on the borrower’s loan is high relative to prevailing interest rates. Conversely, borrowers are less likely to prepay in a rising interest rate environment. However, borrowers may prepay for a variety of other reasons, such as to monetize increases in the underlying collateral values, particularly in the medallion loan portfolio.
In addition, we manage our exposure to increases in market rates of interest by incurring fixed-rate indebtedness, such as ten year subordinated SBA debentures, and by setting repricing on certificates of deposit, for terms of up to five years. We had outstanding SBA debentures of $79,733,000 with a weighted average interest rate of 3.39%, constituting 24% of our total indebtedness, and retail notes of $33,625,000 with a weighted average interest rate of 9.00%, constituting 10% of total indebtedness as of September 30, 2017. Also, as of September 30, 2017, certain of the certificates of deposit were for terms of up to 57 months, further mitigating the immediate impact of changes in market interest rates.
A relative measure of interest rate risk can be derived from our interest rate sensitivity gap. The interest rate sensitivity gap represents the difference between interest-earning assets and interest-bearing liabilities, which mature and/or reprice within specified intervals of time. The gap is considered to be positive when repriceable assets exceed repriceable liabilities, and negative when repriceable liabilities exceed repriceable assets. A relative measure of interest rate sensitivity is provided by the cumulative difference between interest sensitive assets and interest sensitive liabilities for a given time interval expressed as a percentage of total assets.
The following table presents our interest rate sensitivity gap at September 30, 2017, compared to the respective positions at the end of 2016 and 2015. The principal amounts of interest earning assets are assigned to the time frames in which such principal amounts are contractually obligated to be repriced. We have not reflected an assumed annual prepayment rate for such assets in this table.
September 30, 2017 Cumulative Rate Gap(1)
Earning assets
Floating-rate
Adjustable rate
Fixed-rate
Total earning assets
Interest bearing liabilities
DZ Loan
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Interest rate gap
Cumulative interest rate gap(2)
December 31, 2016 (2)
December 31, 2015 (2)
Our interest rate sensitive assets were $382,388,000 and interest rate sensitive liabilities were $330,138,000 at September 30, 2017. The one-year cumulative interest rate gap was a positive $29,031,000 or 8% of interest rate sensitive assets, compared to a negative $4,542,000 or 1% at December 31, 2016 and $114,848,000 or 24% at December 31, 2015. However, using our estimated 40% prepayment/refinancing rate for medallion loans to adjust the interest rate gap resulted in a positive gap of $55,776,000 or 15% at September 30, 2017. We seek to manage interest rate risk by originating adjustable-rate loans, by incurring fixed-rate indebtedness, by evaluating appropriate derivatives, pursuing securitization opportunities, and by other options consistent with managing interest rate risk.
On a combined basis with Medallion Bank, our interest rate sensitive assets were $1,488,897,000 and interest rate sensitive liabilities were $1,274,239,000 at September 30, 2017. The one year cumulative interest rate gap was a negative $214,686,000 or 14% of interest rate sensitive assets, compared to a negative $160,931,000 or 11% and $220,686,000 or 14% at December 31, 2016 and 2015. Using our estimated 40% prepayment/refinancing rate for medallion loans to adjust the interest rate gap resulted in a negative gap of $160,261,000 or 11% at September 30, 2017.
Interest Rate Cap Agreements
We manage our exposure to increases in market rates of interest by periodically purchasing interest rate caps to lock in the cost of funds of our variable-rate debt in the event of a rapid run up in interest rates. We entered into contracts to purchase interest rate caps on $70,000,000 of notional value of principal from various multinational banks, with termination dates ranging to December 2018. The caps provide for payments to us if various LIBOR thresholds are exceeded during the cap terms. Total cap purchases were generally fully expensed when paid, including $0 and $19,000 for the three and nine months ended September 30, 2017, and $10,000 for the comparable 2016 periods, and all are carried at $0 on the balance sheet at September 30, 2017.
Liquidity and Capital Resources
Our sources of liquidity are with a variety of local and regional banking institutions, unfunded commitments to sell debentures to the SBA, loan amortization and prepayments, private issuances of debt securities, participations or sales of loans to third parties, the disposition of other assets of the Company, and dividends from Medallion Bank and Medallion Capital. As a RIC, we were required to distribute at least 90% of our investment company taxable income; consequently, we primarily relied upon external sources of funds to finance growth. However, as of December 31, 2016, and subsequent quarters, we did not qualify for the RIC election, and therefore became subject to taxation as a corporation under Subchapter C of the Code. Additionally, there were $5,500,000 of unfunded commitments from the SBA, $3,500,000 of which would be issued without further capital contribution from us.
Additionally, Medallion Bank, our wholly-owned, unconsolidated portfolio company has access to independent sources of funds for our business originated there, primarily through brokered certificates of deposit. Medallion Bank has $25,000,000 available under Fed Funds lines with several commercial banks. In addition, Medallion Bank is allowed to retain all earnings in the business to fund future growth.
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The components of our debt were as follows at September 30, 2017. See Note 4 to the consolidated financial statements on page 20 for details of the contractual terms of our borrowings.
Total outstanding debt
Deposits and other borrowings at Medallion Bank
Total outstanding debt, including Medallion Bank
Our contractual obligations expire on or mature at various dates through September 2037. The following table shows all contractual obligations at September 30, 2017.
Total, including Medallion Bank
Most of our borrowing relationships have maturity dates during 2017 and 2018. We have been in active and ongoing discussions with each of these lenders and have extended each of the facilities as they matured except as set forth in the following paragraph. The lenders have worked with us to extend and change the terms of the borrowing agreements. We have arranged for changes to the terms of the notes and payment and borrowing base calculations which we anticipate will facilitate our operations for the foreseeable future.
We and our subsidiaries obtain financing under lending facilities extended by various banks and other financial institutions, some of which are secured by loans, taxi medallions and other assets. Where these facilities are extended to our subsidiaries, we and others of our subsidiaries may guarantee the obligations of the relevant borrower. Five of our smallest subsidiaries are borrowers under promissory notes extended to them by a bank that total $8.8 million that came due on October 17, 2016. These loans are secured by Chicago taxi medallions owned by our subsidiaries. These notes are guaranteed by Medallion Funding, not by Medallion Financial Corp. These subsidiaries have not repaid the amounts due under the notes and the bank has filed a suit seeking payment of these amounts. This failure to pay would constitute an event of default under certain loan agreements under which we or our subsidiaries are borrowers, but the lenders under those agreements have waived the default. If judgment is entered against us in the suit brought by the bank or entered and not satisfied within specified periods of time, these outcomes may constitute an additional event of default under these other agreements. If waivers are required and not granted for this additional event of default, it would lead to events of default under other of our financing arrangements.
We value our portfolio at fair value as determined in good faith by the Board of Directors in accordance with our valuation policy. Unlike certain lending institutions, we are not permitted to establish reserves for loan losses. Instead, we must value each individual investment and portfolio loan on a quarterly basis. We record unrealized depreciation on investments and loans when we believe that an asset has been impaired and full collection is unlikely. We record unrealized appreciation on equities if we have a clear
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indication that the underlying portfolio company has appreciated in value and, therefore, our equity investment has also appreciated in value. Without a readily ascertainable market value, the estimated value of our portfolio of investments and loans may differ significantly from the values that would be placed on the portfolio if there existed a ready market for the investments. We adjust the valuation of the portfolio quarterly to reflect our Board of Directors’ estimate of the current fair value of each investment in the portfolio. Any changes in estimated fair value are recorded in our statement of operations as net unrealized appreciation (depreciation) on investments. Our investment in Medallion Bank, as a wholly-owned portfolio investment, is also subject to quarterly assessments of its fair value. We conduct a thorough valuation analysis, and also receive an opinion regarding the valuation from an independent third party to assist the Board of Directors in its determination of the fair value of Medallion Bank. We determine whether any factors give rise to valuation different than recorded book value. As a result of this valuation process, we had previously used Medallion Bank’s actual results of operations as the best estimate of changes in fair value, and recorded the results as a component of unrealized appreciation (depreciation) on investments. In the second quarter of 2015, we first became aware of external interest in Medallion Bank and its portfolio’s assets at values in excess of their book value. Expression of interest in Medallion Bank from both investment bankers and interested parties has continued through 2016 and 2017. We incorporated these new factors in the Medallion Bank’s fair value analysis and the Board of Directors determined that Medallion Bank had a fair value in excess of book value. In addition, in the 2016 third quarter there was a court ruling involving a marketplace lender that we believe heightens the interest of marketplace lenders to acquire or merge with Utah industrial banks. We also engaged a valuation specialist to assist the Board of Directors in its determination of Medallion Bank’s fair value, and this appreciation of $15,500,000 was thereby recorded in 2015, and additional appreciation of $128,918,000 was recorded in 2016, and $563,000 was recorded in 2017. See Note 3 for additional information about Medallion Bank. For more information, see “Risk Factors – Risks Relating to Our Business and Structure – Our investment portfolio is, and will continue to be, recorded at fair value as determined in good faith by our Board of Directors and, as a result, there is, and will continue to be, uncertainty as to the value of our portfolio investments which could adversely affect our net asset value.”
In addition, the illiquidity of our loan portfolio and investments may adversely affect our ability to dispose of loans at times when it may be advantageous for us to liquidate such portfolio or investments. In addition, if we were required to liquidate some or all of the investments in the portfolio, the proceeds of such liquidation may be significantly less than the current value of such investments. Because we borrow money to make loans and investments, our net operating income is dependent upon the difference between the rate at which we borrow funds and the rate at which we invest these funds. As a result, there can be no assurance that a significant change in market interest rates will not have a material adverse effect on our interest income. In periods of sharply rising interest rates, our cost of funds would increase, which would reduce our net operating income before net realized and unrealized gains. We use a combination of long-term and short-term borrowings and equity capital to finance our investing activities. Our long-term fixed-rate investments are financed primarily with short-term floating-rate debt, and to a lesser extent by term fixed-rate debt. We may use interest rate risk management techniques in an effort to limit our exposure to interest rate fluctuations. Such techniques may include various interest rate hedging activities to the extent permitted by the 1940 Act. We have analyzed the potential impact of changes in interest rates on net interest income. Assuming that the balance sheet were to remain constant and no actions were taken to alter the existing interest rate sensitivity, and including the impact on Medallion Bank, a hypothetical immediate 1% increase in interest rates would result in an increase to the line item “net increase in net assets resulting from operations” as of September 30, 2017 by $1,217,000 on an annualized basis, compared to a positive impact of $1,100,000 at December 31, 2016, and the impact of such an immediate increase of 1% over a one year period would have been ($1,422,000) at September 30, 2017, compared to ($792,000) at December 31, 2016. Although management believes that this measure is indicative of our sensitivity to interest rate changes, it does not adjust for potential changes in credit quality, size, and composition of the assets on the balance sheet, and other business developments that could affect net increase in net assets resulting from operations in a particular quarter or for the year taken as a whole. Accordingly, no assurances can be given that actual results would not differ materially from the potential outcome simulated by these estimates.
We continue to work with investment banking firms and other financial intermediaries to investigate the viability of a number of other financing options which include, among others, the sale or spin off certain assets or divisions, the development of a securitization conduit program, and other independent financing for certain subsidiaries or asset classes. These financing options would also provide additional sources of funds for both external expansion and continuation of internal growth.
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The following table illustrates sources of available funds for us and each of our subsidiaries, and amounts outstanding under credit facilities and their respective end of period weighted average interest rates at September 30, 2017. See Note 4 to the consolidated financial statements for additional information about each credit facility.
Bank loans
Average interest rate
Maturity
SBA debentures and other borrowings
Amounts undisbursed (2)
Amounts outstanding
Total debt outstanding
Including Medallion Bank
Total cash
Loan amortization, prepayments, and sales also provide a source of funding for us. Prepayments on loans are influenced significantly by general interest rates, medallion loan market values, economic conditions, and competition.
We also generate liquidity through deposits generated at Medallion Bank, borrowing arrangements with other banks, and through the issuance of SBA debentures, as well as from cash flow from operations. In addition, we may choose to participate a greater portion of our loan portfolio to third parties. We are actively seeking additional sources of liquidity, however, given current market conditions, we cannot assure you that we will be able to secure additional liquidity on terms favorable to us or at all. If that occurs, we may decline to underwrite lower yielding loans in order to conserve capital until credit conditions in the market become more favorable; or we may be required to dispose of assets when we would not otherwise do so, and at prices which may be below the net book value of such assets in order for us to repay indebtedness on a timely basis. Also, Medallion Bank is not a RIC, and therefore is able to retain earnings to finance growth.
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Recently Issued Accounting Standards
In May 2017, the FASB issued Accounting Standards Update (ASU) 2017-09. Compensation – Stock Compensation (Topic 718): Scope of Modification Accounting. The objective of this update is to provide clarity and reduce both diversity in practice and cost and complexity when applying the guidance of Topic 718. The amendments in this update are effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. We are assessing the impact the update will have on our financial condition and results of operations.
In January 2017, the FASB issued ASU 2017-04. “Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” The objective of this update is to simplify the subsequent measurement of goodwill, by eliminating step 2 from the goodwill impairment test. The amendments in this update are effective for annual periods beginning after December 15, 2019, and interim periods within those fiscal years. We do not believe this update will have a material impact on our financial condition.
In August 2016, the FASB issued ASU 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments.” The update clarifies how entities should classify certain cash receipts and cash payments on the statement of cash flows with the objective of reducing the existing diversity in practice related to eight specific cash flow issues. The amendments in this update are effective for annual periods beginning after December 15, 2017, and interim periods within those fiscal years. Early adoption is permitted. We do not expect the adoption of ASU 2016-15 to have a material impact on our consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, “Leases (Topic 842)”. ASU 2016-02 requires the recognition of lease assets and lease liabilities by lessees for leases classified as operating under current GAAP. ASU 2016-02 applies to all entities and is effective for fiscal years beginning after December 15, 2018 for public entities and is effective for fiscal years beginning after December 15, 2019 for all other entities, with early adoption permitted. We are assessing the impact the update will have on our financial condition and results of operations.
In January 2016, the FASB issued ASU 2016-01, “Financial Instruments – Overall (Topic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.” The main objective of this Update is to enhance the reporting model for financial instruments and provide users of financial statements with more decision-useful information. ASU 2016-01 requires equity investments to be measured at fair value, simplifies the impairment assessment of equity investment without readily determinable fair value, eliminates the requirements to disclose the fair value of financial instruments measured at amortized cost, and requires public business entities to use the exit price notion when measuring the fair value of financial instruments. The update, as amended, is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. We do not believe this update will have a material impact on our financial condition.
Common Stock
Our common stock is quoted on NASDAQ under the symbol “MFIN.” Our common stock commenced trading on May 23, 1996. As of November 8, 2017, there were approximately 301 holders of record of our common stock.
On November 8, 2017, the last reported sale price of our common stock was $2.39 per share. Since our initial public offering, our common stock has traded at a premium to net asset value per share more frequently than at a discount to net asset value per share, but there can be no assurance that our stock will trade at a premium in the future.
The following table sets forth, for the periods indicated, the range of high and low closing prices for our common stock on the Nasdaq Global Select Market.
2017
Third Quarter
Second Quarter
First Quarter
2016
Fourth Quarter
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We are subject to federal and applicable state corporate income taxes on our taxable ordinary income and capital gains beginning with our tax year ended December 31, 2016, and are not subject to the annual distribution requirements under Subchapter M of the Code. Thus, there can be no assurance that we will pay any cash distributions as we may retain our earnings in certain circumstances to facilitate the growth of our business, to finance our investments, to provide liquidity or for other corporate purposes.
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We have adopted a dividend reinvestment plan pursuant to which shareholders may elect to have distributions reinvested in additional shares of common stock. When we declare a distribution, all participants will have credited to their plan accounts the number of full and fractional shares (computed to three decimal places) that could be obtained with the cash, net of any applicable withholding taxes that would have been paid to them if they were not participants. The number of full and fractional shares is computed at the weighted average price of all shares of common stock purchased for plan participants within the 30 days after the distribution is declared plus brokerage commissions. The automatic reinvestment of distributions will not release plan participants of any income tax that may be payable on the distribution. Shareholders may terminate their participation in the dividend reinvestment plan by providing written notice to the Plan Agent at least 10 days before any given distribution payment date. Upon termination, we will issue to a shareholder both a certificate for the number of full shares of common stock owned and a check for any fractional shares, valued at the then current market price, less any applicable brokerage commissions and any other costs of sale. There are no additional fees or expenses for participation in the dividend reinvestment plan. Shareholders may obtain additional information about the dividend reinvestment plan by contacting the American Stock Transfer & Trust Company, LLC at 6201 15th Avenue, Brooklyn, NY, 11219.
Issuer Purchases of Equity Securities (1)
Period
November 5 through December 31, 2003
January 1 through December 31, 2004
January 1 through December 31, 2005
January 1 through December 31, 2006
January 1 through December 31, 2007
January 1 through December 31, 2008
January 1 through December 31, 2009
January 1 through December 31, 2010
January 1 through December 31, 2011
January 1 through December 31, 2012
January 1 through December 31, 2013
January 1 through December 31, 2014
January 1 through December 31, 2015
January 1 through December 31, 2016
January 1 through September 30, 2017
Control Statutes
Because Medallion Bank is an “insured depository institution” within the meaning of the Federal Deposit Insurance Act and the Change in Bank Control Act and we are a “financial institution holding company” within the meaning of the Utah Financial Institutions Act, federal and Utah law and regulations prohibit any person or company from acquiring control of us and, indirectly, Medallion Bank, without, in most cases, prior written approval of the FDIC or the Commissioner of Financial Institutions, as applicable. Under the Change in Bank Control Act, control is conclusively presumed if, among other things, a person or company acquires 25% or more of any class of our voting stock. A rebuttable presumption of control arises if a person or company acquires
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10% or more of any class of voting stock and is subject to a number of specified “control factors” as set forth in the applicable regulations. Although MedallionBank is an “insured depository institution” within the meaning of the Federal Deposit Insurance Act and theChange in Bank Control Act, your investment in Medallion Financial Corp. is not guaranteed by the FDIC and issubject to loss. Under the Utah Financial Institutions Act, control is defined as the power to vote 20% or more of any class of our voting securities by an individual or to vote more than 10% of any class of our voting securities by a person other than an individual. Investors are responsible for ensuring that they do not, directly or indirectly, acquire shares of our common stock in excess of the amount which can be acquired without regulatory approval.
There has been no material change in disclosure regarding quantitative and qualitative disclosures about market risk since we filed our Annual Report on Form 10-K for the year ended December 31, 2016.
Under the direction of our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of our disclosure controls and procedures and internal control over financial reporting pursuant to Rules 13a—15(e) and 15d – 15(e) under the Securities Exchange Act of 1934, and have concluded that they are effective as of September 30, 2017. In addition, based on our evaluation as of September 30, 2017, there have been no changes that occurred during the 2017 nine months that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II - OTHER INFORMATION
We and our subsidiaries are currently involved in various legal proceedings incident to the ordinary course of our business, including collection matters with respect to certain loans. We intend to vigorously defend any outstanding claims and pursue our legal rights. In the opinion of our management and based upon the advice of legal counsel, other than as set forth in the following paragraph there is no proceeding pending, or to the knowledge of management threatened, which in the event of an adverse decision could result in a material adverse effect on our results of operations or financial condition.
We and our subsidiaries obtain financing under lending facilities extended by various banks and other financial institutions, some of which are secured by loans, taxi medallions and other assets. Where these facilities are extended to our subsidiaries, we and others of our subsidiaries may guarantee the obligations of the relevant borrower. Five of our smallest subsidiaries are borrowers under promissory notes extended to them by a bank that total $8.8 million that came due on October 17, 2016. These loans are secured by Chicago taxi medallions owned by our subsidiaries. These notes are guaranteed by Medallion Funding, not by Medallion Financial Corp. These subsidiaries have not repaid the amounts due under the notes and the bank has filed a suit seeking payment of these amounts. This failure to pay would constitute an event of default under certain loan agreements which we or our subsidiaries are borrowers, but the lenders under those agreements have waived the default. If judgment is entered against us in the suit brought by the bank or entered and not satisfied within specified periods of time, these outcomes may constitute an additional event of default under these other agreements. If waivers are required and not granted for this additional event of default, it would lead to events of default under other of our financing arrangements.
Risks Relating to Our Business and Structure
Changes in the taxicab and for-hire vehicle industries have resulted in increased competition and have had a material adverse effect on our business, financial condition, and operations.
There have been recent changes in the taxicab and for-hire vehicle industries that have resulted in increased competition in all of our taxi medallion markets. Ridesharing applications, or ridesharing apps, utilized by for-hire vehicles were introduced in New York City in 2011 and continue to expand domestically and globally. Many of these for-hire vehicle operators operate outside of the regulatory regime with which we and our borrowers operate, which poses an increased risk of competition because such operators are able to pass the cost savings of not having to comply with certain regulations to its passengers. According to the TLC, between January 2016 and October 2017 approximately 30,600 new for-hire vehicle licenses were issued, increasing the total number of for-hire vehicles to approximately 102,100 as of October 31, 2017, a 43% increase from January 2016.
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In addition, the New York State legislature enacted a law on December 21, 2011, which was amended on February 17, 2012, to permit cars for-hire to pickup street hails in boroughs outside of Manhattan. Pursuant to this law the TLC has issued approximately 8,300 Street Hail Livery licenses since June 2013, of which approximately 4,200 are active.
TLC annualized data through December 2016 has shown a 9.3% reduction in total New York City taxicab fares, compared to the same period in 2015, and a 10.7% reduction in the total number of New York City taxicab trips. Such reductions in fare totals and taxicab trips are likely the result of a combination of ridesharing apps, Street Hail Livery licenses, and other forms of public transportation.
As of September 30, 2017, 22.8% of our managed medallion loan portfolio and 35.3% of our on-balance sheet medallion loan portfolio was 90 days or more past due, compared to 18.8% and 24.4% at December 31, 2016. As discussed in further detail below, there have also been recent decreases in the values of our medallion loan collateral and our Chicago medallions purchased out of foreclosure. Increased competition from ridesharing apps and Street Hail Livery licenses has reduced our market share, the overall market for taxicab services, the supply of taxicab drivers, income from operating medallions, and the value of taxicab medallions. If these trends continue and intensify, there would be a further material increase to our loan to value ratios, loan delinquencies, and loan defaults resulting in a material adverse effect on our business, financial condition, and results of operations.
Decreases in the value of our medallion loan collateral and our Chicago medallions purchased out of foreclosure have had a material adverse effect on our business.
A significant portion of our loan revenue is derived from loans collateralized by New York City taxicab medallions. According to TLC data, over the past 20 years New York City taxicab medallions had appreciated in value from under $200,000 to $1,320,000 for corporate medallions and $1,050,000 for individual medallions in 2014. As reported by the TLC, individual (owner-driver) medallions and corporate medallions sold for a wide range of prices during the 2017 third quarter. Like many other financial institutions, we evaluate the transactions and cash flows underlying borrower performance and determined that a market value of $370,000, $359,000 net of liquidation costs, was appropriate, reflecting a blend of transactional activity and values supported by borrower cash flows. In March 2017, the New York City Council made changes to the medallion classes, eliminating the distinction between individual and corporate medallions. We are not yet sure of the ultimate impact of this change.
We own 159 Chicago taxicab medallions that were purchased out of foreclosure in 2003. Additionally, a portion of our loan revenue is derived from loans collateralized by Chicago taxicab medallions. The Chicago medallions had appreciated in value from $50,000 in 2003 to approximately $370,000 in 2013. Since that time, however, there has been a decline in the value of Chicago taxicab medallions to approximately $60,000 as of September 30, 2017.
Decreases in the value of our medallion loan collateral have resulted in an increase in the loan-to-value ratios of our medallion loans. We estimate that the weighted averageloan-to-value ratio of our managed medallion loans was approximately 143% as of September 30, 2017 and 129% as of December 31, 2016. If taxicab medallion values continue to decline, there would be an increase in medallion loan delinquencies, foreclosures and borrower bankruptcies. Our ability to recover on defaulted medallion loans by foreclosing on and selling the medallion collateral would be diminished, which would result in material losses on defaulted medallion loans which would have a material adverse effect on our business. A substantial decrease in the value of our Chicago medallions purchased out of foreclosure would adversely affect our ability to dispose of such medallions at times when it may be advantageous for us to do so. If we are required to liquidate all or a portion of our medallions quickly, we would realize less than the value at which we had previously recorded such medallions.
We borrow money, which magnifies the potential for gain or loss on amounts invested, and may increase the risk of investing in us.
Borrowings, also known as leverage, magnify the potential for gain or loss on amounts invested, and therefore increase the risk associated with investing in us. We borrow from and issue senior debt securities to banks and other lenders, and through long-term subordinated SBA debentures. These creditors have fixed dollar claims on our assets that are superior to the claims of our shareholders. If the value of our assets increases, then leveraging would cause the net asset value to increase more sharply than it would have had we not leveraged. Conversely, if the value of our assets decreases, leveraging would cause net asset value to decline more sharply than it otherwise would have had we not leveraged. Similarly, any increase in our income in excess of interest payable on the borrowed funds would cause our net income to increase more than it would without the leverage, while any decrease in our income would cause net income to decline more sharply than it would have had we not borrowed. Such a decline could reduce the amount available for distribution payments.
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As of September 30, 2017, we had $330,138,000 of outstanding indebtedness, which had a weighted average borrowing cost of 3.93% at September 30, 2017, and our wholly-owned unconsolidated portfolio companies, primarily Medallion Bank, had $944,101,000 of outstanding indebtedness at a weighted average borrowing cost of 1.47%.
Most of our borrowing relationships have maturity dates during 2017 and 2018. We have been in active and ongoing discussions with each of these lenders and have extended each of the facilities as they matured except as set forth in the following risk factor. Certain lenders have worked with us to extend and change the terms of the borrowing agreements. See note 4 for a discussion of the current and new lending arrangements to date.
Failure to obtain an extension of our existing credit facilities or failure to obtain additional revolving credit facilities could have a material adverse effect on our results of operations and financial position.
We utilize secured revolving credit facilities and other facilities to fund our investments. We cannot guarantee that our credit facilities will continue to be available beyond their current maturity dates on reasonable terms or at all or that we will be able to otherwise obtain funds by selling assets or raising equity to make required payments on maturing indebtedness. Our revolving credit facilities have converted to term loans. Obtaining additional revolving credit facilities or other alternative sources of financing may be difficult and we cannot guarantee that we will be able to do so on terms favorable to us or at all. The availability of revolving credit facilities depends, in part, on factors outside of our control, including regulatory capital treatment for unfunded bank lines of credit, the financial strength and strategic objectives of the banks that participate in our credit facilities and the availability of bank liquidity in general. If the credit facilities are not renewed or extended by our lenders by their maturity dates, we will not be able to make further borrowings under the facilities after they mature and the outstanding principal balances under such facilities will be due and payable at maturity. If we are unable to refinance our indebtedness at maturity or meet our payment obligations, our financial condition would be adversely affected and our lenders may foreclose on the property securing such indebtedness. If we are unable to extend or replace these facilities or arrange new credit facilities or other types of interim financing, we may need to curtail or suspend loan origination and funding activities which could have a material adverse effect on our results of operations and financial position.
We are subject to certain financial covenants and other restrictions under our loan and credit arrangements, which could affect our ability to finance future operations or capital needs or to engage in other business activities.
Our loan and credit agreements contain financial covenants and other restrictions relating to borrowing base eligibility, tangible net worth, net income, leverage ratios, shareholders’ equity, and collateral values. Our ability to meet these financial covenants and restrictions could be affected by events beyond our control, such as a substantial decline in collateral values or a rise in borrower delinquencies. A breach of these covenants could result in an event of default under the applicable debt instrument. Such a default, if not cured or waived, may allow the creditors to accelerate the related debt and may result in the acceleration of any other debt that is subject to an applicable cross-acceleration or cross-default provision. Certain other events can constitute an event of default. Furthermore, if we were unable to repay the amounts due and payable under our credit facilities, those lenders could proceed against the collateral granted to them to secure that indebtedness. In the event our lenders or holders of the related notes accelerate the repayment of our borrowings, we and our subsidiaries may not have sufficient assets to repay that indebtedness. Based on the foregoing factors, the operating and financial restrictions and covenants in our current credit agreements and any future financing agreements could adversely affect our ability to finance future operations or capital needs or to engage in other business activities.
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Consumer lending by Medallion Bank carries a higher risk of loss and could be adversely affected by an economic downturn.
By its nature, lending to consumers carries with it a higher risk of loss than commercial lending. Although the net interest margins should be higher to compensate Medallion Bank for this increased risk, an economic downturn could result in higher loss rates and lower returns than expected, and could affect the profitability of Medallion Bank’s consumer loan portfolio.
We are dependent upon our key investment personnel for our future success.
We depend on the diligence, skill, and network of business contacts of the investment professionals we employ for sourcing, evaluating, negotiating, structuring, and monitoring our investments. Our future success will also depend, to a significant extent, on the continued service and coordination of our senior management team, particularly, Alvin Murstein, our Chairman and Chief Executive Officer, Andrew M. Murstein, our President, and Larry D. Hall, our Chief Financial Officer. The departure of Messrs. Murstein or Mr. Hall, or any member of our senior management team, could have a material adverse effect on our ability to achieve our investment objective.
Changes in taxicab industry regulations that result in the issuance of additional medallions or increases in the expenses involved in operating a medallion would lead to a decrease in the value of our medallion loan collateral and our Chicago medallions purchased out of foreclosure.
Every city in which we originate medallion loans, and most other major cities in the United States, limits the supply of taxicab medallions. This regulation results in supply restrictions that support the value of medallions. Actions that loosen these restrictions and result in the issuance of additional medallions into a market could decrease the value of medallions in that market. If this were to occur, the value of the collateral securing our then outstanding medallion loans in that market would be adversely affected. We are unable to forecast with any degree of certainty whether any other potential increases in the supply of medallions will occur.
In New York City, Chicago, Boston, and other markets where we originate medallion loans, taxicab fares are generally set by government agencies. Expenses associated with operating taxicabs are largely unregulated. As a result, the ability of taxicab operators to recoup increases in expenses is limited in the short term. Escalating expenses, such as rising gas prices and an increase in interest rates, can render taxicab operations less profitable, could cause borrowers to default on loans from us and would adversely affect the value of our collateral.
We operate in a highly regulated environment, and if we are found to be in violation of any of the federal, state, or local laws or regulations applicable to us, our business could suffer.
The 1940 Act imposes numerous constraints on the operations of BDC’s. For example, BDC’s are required to invest at least 70% of their total assets in qualifying assets, primarily securities of “eligible portfolio companies” (as defined under the 1940 Act), cash, cash equivalents, US government securities, and other high quality debt investments that mature in one year or less. Our regulatory requirements may hinder our ability to take advantage of attractive investment opportunities and, as a result, achieve our investment objective. In addition, we rely upon several exemptive orders from the SEC permitting us to consolidate our financial reporting and operate our business as presently conducted. Our failure to satisfy the conditions set forth in those exemptive orders could result in our inability to rely upon such orders or to cause the SEC to revoke the orders which could result in material changes in our financial reporting or the way in which we conduct our business. Furthermore, any failure to comply with the requirements imposed on BDC’s by the 1940 Act could have material adverse consequences to us or our investors, including possible enforcement action by the SEC. If we do not remain a BDC, we might be regulated as a closed-end investment company under the 1940 Act, which would further significantly decrease our operating flexibility.
The Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, was enacted in 2010. The Dodd-Frank Act significantly changed federal financial services regulation and affects, among other things, the lending, deposit, investment, trading, and operating activities of financial institutions and their holding companies. In addition to the statutory requirements under the Dodd-Frank Act, the legislation also delegated authority to US banking, securities and derivatives regulators to impose additional restrictions through required rulemaking. The Dodd-Frank Act requires a company that owns an industrial bank to serve as a “source of strength” to the institution. We believe that we have historically served, and will serve in the future, as a source of strength to our industrial bank subsidiary, Medallion Bank. We do not believe that the codification of this requirement under the Dodd-Frank Act materially impacts our obligations. A company that owns an industrial bank is also subject to the Dodd-Frank Act “Volcker Rule.” We do not believe that the “Volcker Rule” materially impacts our operations as presently conducted.
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Other changes in the laws or regulations applicable to us more generally, may negatively impact the profitability of our business activities, require us to change certain of our business practices, materially affect our business model, limit the activities in which we may engage, affect retention of key personnel, require us to raise additional regulatory capital, increase the amount of liquid assets that we hold, otherwise affect our funding profile or expose us to additional costs (including increased compliance costs). Any such changes may also require us to invest significant management attention and resources to make any necessary changes and may adversely affect our ability to conduct our business as previously conducted or our results of operations or financial condition.
We are also subject to a wide range of federal, state, and local laws and regulations, such as local licensing requirements, and retail financing, debt collection, consumer protection, environmental, health and safety, creditor, wage-hour, anti-discrimination, whistleblower and other employment practices laws and regulations and we expect these costs to increase going forward. The violation of these or future requirements or laws and regulations could result in administrative, civil, or criminal sanctions against us, which may include fines, a cease and desist order against the subject operations or even revocation or suspension of our license to operate the subject business. As a result, we have incurred and will continue to incur capital and operating expenditures and other costs to comply with these requirements and laws and regulations.
Changes in laws, regulations, or policies may adversely affect our business.
The post-financial crisis era has been marked by an increase in regulation, regulatory intensity, and enforcement. We are unable to predict all of the ways in which this change in the regulatory environment could impact our business models or objectives. The laws and regulations governing our lending, servicing, and debt collection activities or the regulatory or enforcement environment at the federal level or in any of the states in which we operate may change at any time which may have an adverse effect on our business.
We expect, however, to see an increase over time in regulatory scrutiny and enforcement in the area of consumer financial products regulation, as a result of the establishment of the Consumer Financial Protection Bureau, or the CFPB, by the Dodd-Frank Act. The CFPB is responsible for interpreting and enforcing a broad range of consumer protection laws that govern the provision of deposit accounts and the making of loans, including the regulation of mortgage lending and servicing and automobile finance. While Medallion Bank’s size currently falls below the threshold that would give the CFPB direct authority over it, Medallion Bank’s existing bank supervisors may pursue similar policies and make similar information requests to those of the CFPB with respect to consumer financial products and other matters within the scope of the CFPB’s authority. We believe that the CFPB’s regulatory reforms, together with other provisions of the Dodd-Frank Act, and increased regulatory supervision, may increase our cost of doing business, impose new restrictions on the way in which we conduct our business, or add significant operational constraints that might impair our profitability.
We are unable to predict how these or any other future legislative proposals or programs will be administered or implemented or in what form, or whether any additional or similar changes to statutes or regulations, including the interpretation or implementation thereof, will occur in the future. Any such action could affect us in substantial and unpredictable ways and could have an adverse effect on our results of operations and financial condition.
Our inability to remain in compliance with regulatory requirements in a particular jurisdiction could have a material adverse effect on our operations in that market and on our reputation generally. No assurance can be given that applicable laws or regulations will not be amended or construed differently or that new laws and regulations will not be adopted, either of which could materially adversely affect our business, financial condition, or results of operations.
Federal and state law may discourage certain acquisitions of our common stock which could have a material adverse effect on our shareholders.
Because Medallion Bank is an “insured depository institution” within the meaning of the Federal Deposit Insurance Act and the Change in Bank Control Act and we are a “financial institution holding company” within the meaning of the Utah Financial Institutions Act, federal and Utah law and regulations prohibit any person or company from acquiring control of us and, indirectly Medallion Bank, without, in most cases, prior written approval of the FDIC or the Commissioner of the Utah Department of Financial Institutions, as applicable. Under the Change in Bank Control Act, control is conclusively presumed if, among other things, a person or company acquires 25% or more of any class of our voting stock. A rebuttable presumption of control arises if a person or company acquires 10% or more of any class of voting stock and is subject to a number of specified “control factors” as set forth in the applicable regulations. Under the Utah Financial Institutions Act, control is defined as the power to vote 20% or more of any class of our voting securities by an individual or to vote more than 10% of any class of our voting securities by a person other than an individual. Investors are responsible for ensuring that they do not, directly or indirectly, acquire shares of our common stock in excess of the amount which can be acquired without regulatory approval. These provisions could delay or prevent a third party from acquiring us, despite the possible benefit to our shareholders, or otherwise adversely affect the market price of our common stock. Although Medallion Bank is an “insured depository institution” within themeaning of the Federal Deposit Insurance Act and the Change in Bank Control Act, your investment in MedallionFinancial Corp. is not insured or guaranteed by the FDIC, or any other agency, and is subject to loss.
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Regulations governing our operation as a BDC may affect our ability to, and the way in which, we raise additional capital.
Our business may periodically require capital. We may acquire additional capital from the following sources:
Senior Securities and Other Indebtedness. We may issue debt securities or preferred stock, and/or borrow money from banks or other financial institutions, which we refer to collectively as senior securities, up to the maximum amount permitted by the 1940 Act. If we issue senior securities, including debt or preferred stock, we will be exposed to additional risks, including the following:
Additional Common Stock. We are not generally able to issue and sell our common stock at a price below net asset value (less any distributing commission or discount) per share. We may, however, sell our common stock, warrants, options, or rights to acquire our common stock, at a price below the current net asset value of the common stock if our Board of Directors determines that such sale is in our best interests and that of our shareholders, and our shareholders approve such sale. In any such case, the price at which our securities are to be issued and sold may not be less than a price which, in the determination of our Board of Directors, closely approximates the market value of such securities (less any distributing commission or discount). We may also make rights offerings to our shareholders at prices per share less than the net asset value per share, subject to applicable requirements of the 1940 Act. If we raise additional funds by issuing more common stock or senior securities convertible into, or exchangeable for, our common stock, the percentage ownership of our shareholders at that time would decrease and they may experience dilution. Moreover, we can offer no assurance that we will be able to issue and sell additional equity securities in the future, on favorable terms or at all.
Since our investments in assets that are not “qualifying assets” exceeded 30% of our total assets as of September 30, 2017, we are precluded from making any follow-on investments in Medallion Bank and our City of Chicago taxicab medallions purchased out of foreclosure, and could be precluded from investing in what we believe are attractive investments, which could have a material adverse effect on our business.
As a business development company, we are not permitted to acquire any assets other than “qualifying assets” unless, at the time of such acquisition, at least 70% of our total assets are qualifying assets. Our investment in Medallion Bank and City of Chicago taxicab medallions purchased out of foreclosure, which are carried in investments other than securities on the consolidated balance sheet, are non-qualifying assets. As of September 30, 2017, the percentage of our total assets that were invested in non-qualifying assets were up to 56.8% on an unconsolidated basis and up to 46.6% on a consolidated basis. We did not satisfy the requirement that no more than 30% of our total assets be comprised of non-qualifying assets, and are currently not permitted to acquire any non-qualifying assets. We are therefore unable to make any investments in non-qualifying assets, including follow-on investments in Medallion Bank and our City of Chicago taxicab medallions purchased out of foreclosure. As a result of such failure, we could also be precluded from investing in what we believe are attractive investments or could be required to dispose of non-qualifying assets at times or on terms that may be disadvantageous to us. We would also not be able to support Medallion Bank’s capital requirements, if
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any, and Medallion Bank may also not be able to grow as quickly because we are precluded from providing additional funding to Medallion Bank. Any of the foregoing consequences could have a material adverse effect on us. If we purchase a non-qualifying asset after failing to satisfy the requirement that no more than 30% of our total assets be comprised ofnon-qualifying assets, then we would be deemed to be in violation of the 1940 Act and the violation could also result in an event of default on our debt obligations.
We are exploring measures to return the amount of qualifying assets to at least 70% of our total assets. However, we cannot guarantee that we will be able to do so. At the end of each fiscal quarter, we may take proactive steps to prospectively preserve investment flexibility in the next quarter which is assessed against our total assets at our most recent quarter end. We can accomplish this in many ways including purchasing US Treasury bills or other investment-grade debt securities, and closing out our position on a net cash basis subsequent to quarter end. However, if such proactive measures are ineffective or our primary investments are deemed not to be qualifying assets, or if the fair value of our non-qualifying assets increases or is determined to be higher than previously determined, or if the fair value of our qualifying assets decreases or is determined to be lower than previously determined, we could continue to fail to satisfy the requirement that no more than 30% of our total assets be comprised of non-qualifying assets.
Change in the Company’s Tax Classification.
RIC qualification rules require that at the end of each quarter of our taxable year, (i) at least 50% of the market value of our assets must be represented by cash, securities of other RICs, US government securities, and other securities, with such other securities limited, in respect of any one issuer, to an amount not greater than 5% of our assets and not greater than 10% of the outstanding voting securities of such issuer and (ii) not more than 25% of the value of our assets may be invested in the securities (other than US government securities or securities of other RICs) of any one issuer, any two or more issuers of which 20% or more of the voting stock is held by us and that are determined to be engaged in the same or similar trades or businesses or related trades or businesses or in the securities of one or more qualified publicly traded partnerships. We monitor our compliance with these asset tests and any other investment concentrations in conjunction with the diversification tests. As of December 31, 2016 our largest investment subject to this test was our investment in Medallion Bank, representing 51.1% of our RIC assets, and no other investments were more than 5% of our RIC assets. As a result of our failure of the 25% asset diversification test, we were not eligible to file our tax returns as a RIC for 2016. As of September 30, 2017 our investment in Medallion Bank was 51.1% of our RIC assets, which would make us ineligible to file as a RIC for 2017.
Because we do not meet the qualifications for RIC tax treatment for the tax year ended December 31, 2016, and now we are subject to corporate income tax, the resulting corporate taxes could substantially reduce our net assets, the amount of income available for distribution and the amount of our distributions. Qualification as a RIC is made on an annual basis and, although we and some of our subsidiaries have qualified in the past, we cannot assure you that we will qualify for such treatment in the future.
If we do not qualify as a RIC for more than two consecutive years, and then seek to requalify and elect RIC status, we would be required to recognize gain to the extent of any unrealized appreciation on our assets unless we make a special election to pay corporate-level tax on any such unrealized appreciation recognized during the succeeding 10-year period.
To obtain and maintain RIC tax treatment under the Code in any future taxable year, we must meet the following annual distribution, income source, and asset diversification requirements.
If we meet the requirements to be treated as a RIC in a future tax year, for US federal income tax purposes, we would have to include in taxable income certain amounts that we would not have yet received in cash, such as original issue discount, which may arise if we received warrants in connection with the origination of a loan or possibly in other circumstances, or contractual payment-
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in-kind interest, which represents contractual interest added to the loan balance and due at the end of the loan term. Such original issue discount or increases in loan balances as a result of payment-in-kind interest will be included in income before we receive any corresponding cash payments. We also may be required to include in income certain other amounts that we will not receive in cash.
Since, in certain cases, we may recognize income before or without receiving cash representing such income, we may have difficulty meeting the annual distribution requirement necessary to achieve and maintain RIC tax treatment under the Code. Accordingly, we may have to sell some of our investments at times and/or at prices we would not consider advantageous, raise additional debt or equity capital, or reduce new investment originations for this purpose. If we are not able to obtain cash from other sources, we may fail to qualify for RIC tax treatment and thus become subject to corporate-level income tax.
As Medallion Bank grows, a greater portion of our business will be subject to corporate-level tax.
Medallion Bank must pay corporate-level US federal and state income taxes. As Medallion Bank grows its business, more of its income will be taxed, which will reduce the amount of cash available for distribution to us and, in turn, to our shareholders.
Our SBIC subsidiaries may be unable to meet the investment company requirements, which could result in the imposition of an entity-level tax.
Some of our subsidiaries are subject to the SBIA. Our SBIC subsidiaries that are RICs may be prohibited by the SBIA from making the distributions necessary to qualify as a RIC. The SBA has agreed that our SBIC subsidiaries can make these distributions provided we reinvest the distributions in our SBIC subsidiaries as undistributed net realized earnings. We cannot assure you that this will continue to be the SBA’s policy or that our subsidiaries will have adequate capital to make the required adjustments. If our subsidiaries are unable to obtain a waiver, compliance with the SBA regulations may result in loss of RIC status and a consequent imposition of an entity-level tax at the subsidiary level. In the event we are granted a waiver, we will be required to reinvest the distribution into the SBIC as capital. This may result in us recognizing taxable income without receiving a corresponding amount of cash to pay the distribution. Any failure to pay the distribution could cause a loss of RIC status and the imposition of entity level tax.
Our SBIC subsidiaries are licensed by the SBA, and are therefore subject to SBA regulations.
Our SBIC subsidiaries are licensed to operate as SBICs and are regulated by the SBA. The SBA also places certain limitations on the financing terms of investments by SBICs in portfolio companies and prohibits SBICs from providing funds for certain purposes or to businesses in a few prohibited industries. Compliance with SBA requirements may cause the SBIC subsidiaries to forego attractive investment opportunities that are not permitted under SBA regulations.
Further, SBA regulations require that a licensed SBIC be periodically examined and audited by the SBA to determine its compliance with the relevant SBA regulations. The SBA prohibits, without prior SBA approval, a “change of control” of an SBIC or transfers that would result in any person (or a group of persons acting in concert) owning 10% or more of a class of capital stock of an SBIC. If the SBIC subsidiaries fail to comply with applicable SBIC regulations, the SBA could, depending on the severity of the violation, limit or prohibit their use of debentures, declare outstanding debentures immediately due and payable, and/or limit them from making new investments. In addition, the SBA could revoke or suspend an SBIC license or bring a suit for the appointment of a receiver for the SBIC and for its liquidation for willful or repeated violation of, or willful or repeated failure to observe, any provision of the SBIA or any rule or regulation promulgated thereunder. Such actions by the SBA would, in turn, negatively affect us.
We may materially change our corporate structure and the nature of our business.
We are very much affected by the legal, regulatory, tax and accounting regimes under which we operate. We periodically evaluate whether those regimes and our existing corporate structure are the optimum means for the operation and capitalization of our business. As a result of these evaluations, we may decide to proceed with structural and organizational changes (certain of which may require the approval of our shareholders), which could result in material dispositions of various assets, changes in our corporate form, withdrawal of our election to be regulated as a BDC, our conversion from an investment company to an operating company or other fundamental changes. If we were no longer an investment company, our accounting practices, among others would change and lead to the consolidation of certain majority owned companies for financial reporting purposes that we do not currently consolidate as an investment company. Additionally, if we were no longer an investment company, our shareholders would not benefit from the investor protections provided by the 1940 Act. We may incur certain costs in completing these evaluations and may receive no benefit from these expenditures, particularly if we do not proceed with any changes. No decisions have been made with respect to any such changes and there is no timetable for making any decisions, including any decision not to proceed with any such changes.
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We operate in a highly competitive market for investment opportunities.
We compete for investments with other business development companies and other investment funds as well as traditional financial services companies such as commercial banks and credit unions. Many of our competitors are substantially larger and have considerably greater financial, technical, and marketing resources than we do. For example, some competitors may have a lower cost of funds and access to funding sources that are not available to us. In addition, some of our competitors may have higher risk tolerances or different risk assessments. These characteristics could allow our competitors to consider a wider variety of investments, establish more relationships, and offer better pricing and more flexible structuring than us. We may be unwilling to match our competitors’ pricing, terms, and structure of certain loans and investments opportunities due to potential risks, which may result in us earning less income than our competitors. If we are forced to match our competitors’ pricing, terms, and structure, we may not be able to achieve acceptable returns on our investments or may bear substantial risk of capital loss. Furthermore, many of our competitors are not subject to the regulatory restrictions that the 1940 Act imposes on us as a BDC.
We cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition, and results of operations. Also, as a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time.
Changes in interest rates may affect our cost of capital and net investment income.
Because we borrow to fund our investments, a portion of our income is dependent upon the difference between the interest rate at which we borrow funds and the interest rate at which we invest these funds. A portion of our investments, such as taxi medallion loans, will have fixed interest rates, while a portion of our borrowings will likely have floating interest rates. As a result, a significant change in market interest rates could have a material adverse effect on our net investment income. In periods of rising interest rates, our cost of funds could increase, which would reduce our net investment income. We may hedge against interest rate fluctuations by using standard hedging instruments, subject to applicable legal requirements. These activities may limit our ability to participate in the benefits of lower interest rates with respect to the hedged portfolio. Adverse developments resulting from changes in interest rates or hedging transactions could have a material adverse effect on our business, financial condition, and results of operations. Also, we will have to rely on our counterparties to perform their obligations under such hedges.
A decrease in prevailing interest rates may lead to more loan prepayments, which could adversely affect our business.
Our borrowers generally have the right to prepay their loans upon payment of a fee ranging from 1% to 2% for standard commodity loans, and for higher amounts, as negotiated, for larger more custom loan arrangements. A borrower is likely to exercise prepayment rights at a time when the interest rate payable on the borrower’s loan is high relative to prevailing interest rates. In a lower interest rate environment, we will have difficulty re-lending prepaid funds at comparable rates, which may reduce the net interest income that we receive. When this occurs, we will generally reinvest these proceeds in temporary investments, pending their future investment in new portfolio companies. These temporary investments will typically have substantially lower yields than the debt being prepaid, and we could experience significant delays in reinvesting these amounts. Any future investment in a new portfolio company may also be at lower yields than the debt that was repaid. As a result, our results of operations could be materially adversely affected if a substantial number of our portfolio companies elect to prepay amounts owed to us and we are not able to reinvest the proceeds for comparable yields in a timely fashion. Additionally, prepayments could negatively impact our return on equity, which could result in a decline in the market price of our common stock.
An increase in prevailing interest rates could adversely affect our business.
The majority of our loan portfolio is comprised of fixed-rate loans. An abrupt increase in market rates of interest may have an adverse impact on our earnings until we are able to originate new loans at higher prevailing interest rates.
We depend on cash flow from our subsidiaries to make distribution payments to our shareholders.
We are primarily a holding company, and we derive most of our operating income and cash flow from our subsidiaries. As a result, we rely heavily upon distributions from our subsidiaries to generate the funds necessary to make distribution payments to our shareholders. Funds are provided to us by our subsidiaries through dividends and payments on intercompany indebtedness, but we cannot assure you that our subsidiaries will be in a position to continue to make these dividend or debt payments. The Utah Department of Financial Institutions and FDIC have the authority to prohibit or to limit the payment of dividends by Medallion Bank. In addition, as a condition to receipt of FDIC insurance, Medallion Bank entered into a capital maintenance agreement with the FDIC requiring it to maintain a 15% leverage ratio (Tier 1 capital to average assets). As of September 30, 2017 Medallion Bank’s leverage ratio was 15.4% and Medallion Bank may be restricted from declaring and paying dividends if doing so were to cause the leverage ratio to fall below 15%.
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Medallion Bank’s use of brokered deposit sources for its deposit-gathering activities may not be available when needed.
Medallion Bank relies on the established brokered deposit market to originate deposits to fund its operations. Medallion Bank’s brokered deposits consist of deposits raised through the brokered deposit market rather than through retail branches. While Medallion Bank has developed contractual relationships with a diversified group of investment brokers, and the brokered deposit market is well developed and utilized by many banking institutions, conditions could change that might affect the availability of deposits. If the capital levels at Medallion Bank fall below the “well-capitalized” level as defined by the FDIC or the capital level currently required by the FDIC pursuant to its capital maintenance agreement, or if Medallion Bank experiences a period of sustained operating losses, the cost of attracting deposits from the brokered deposit market could increase significantly, and the ability of Medallion Bank to raise deposits from this source could be impaired. Brokered deposits may also not be as stable as other types of deposits. Medallion Bank’s ability to manage its growth to stay within the “well-capitalized” level, and the capital level currently required by the FDIC pursuant to its capital maintenance agreement, which is also considerably higher than the level required to be classified as “well-capitalized”, is critical to Medallion Bank’s retaining open access to this funding source.
Our investment portfolio is, and will continue to be, recorded at fair value as determined in good faith by our Board of Directors and, as a result, there is, and will continue to be, uncertainty as to the value of our portfolio investments which could adversely affect our net asset value.
Under the 1940 Act, we are required to carry our portfolio investments at market value or, if there is no readily available market value, at fair value as determined by our Board of Directors. Unlike other lending institutions, we are not permitted to establish reserves for loan losses. Instead, we are required by the 1940 Act to specifically value each individual investment and record an unrealized gain or loss for any asset we believe has increased or decreased in value. Typically, there is not a public market for most of the investments in which we have invested and will generally continue to invest. As a result, our Board of Directors values our investments on a quarterly basis based on a determination of their fair value made in good faith and in accordance with the written guidelines approved by our Board of Directors. Our Board of Directors regularly reviews the appropriateness and accuracy of the method used in valuing our investments, and makes any necessary adjustments. The types of factors that may be considered in determining the fair value pricing of our investments include the nature and realizable value of any collateral, the portfolio company’s earnings and its ability to make payments on its indebtedness, the markets in which the portfolio company does business, market conditions for loans (e.g., values used by other lenders and any active bid/ask market), comparison to publicly traded companies, discounted cash flow, comparable sales and valuations of companies similar to the portfolio company, regulatory factors that may limit the value of the portfolio company, and other relevant factors. Because such valuations, and particularly valuations of private securities and private companies, are inherently uncertain, the valuations may fluctuate over short periods of time and may be based on estimates. As a result, our determinations of fair value may differ materially from the values that would have been used if a ready market for these investments existed, and may cause our net asset value on a given date to materially understate or overstate the value that we may ultimately realize upon the sale or disposition of one or more of our investments. Investors purchasing our securities in connection with an offering based on an overstated net asset value would pay a higher price than the value of our investments might warrant, and investors purchasing our securities in connection with an offering based on an understated net asset value would pay a lower price than the value of our investments might warrant. Our net asset value could be adversely affected if our determinations regarding the fair value of our investments were materially higher than the values that we ultimately realize upon the disposal of such securities. Considering these factors, we have determined that the fair value of our portfolio is above its cost basis. As of September 30, 2017, our net unrealized appreciation on investments was $100,163,000 or 19.2% of our investment portfolio at cost, and the appreciation on our investments other than securities and other assets was $569,000 or 6% of our investments other than securities and other assets at cost.
Uncertainty relating to the reporting of collateral values for our loans may adversely affect the value of our portfolio.
Medallion loans are primarily collateral-based lending, whereby the collateral value exceeds the amount of the loan, providing sufficient excess collateral to protect us against losses. Collateral values for medallion loans reflect recent sales prices and are typically obtained from the regulatory agency in a particular local market. We rely on the integrity of the collateral value benchmarks obtained by the applicable regulatory agencies and other third parties. If these benchmarks are artificially influenced by market participants we could suffer losses. We have experienced a significant downward movement in medallion collateral values which may continue, and has caused a negative impact on our valuation analysis and could result in a significantly lower fair market value measurement of our portfolio.
We require an objective benchmark in determining the fair value of our portfolio. If the benchmarks that we currently use are deemed to be unreliable, we will need to use other intrinsic factors in determining the collateral values for our loans.
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The lack of liquidity in our investments may adversely affect our business.
We generally make investments in private companies. Substantially all of these securities are subject to legal and other restrictions on resale or are otherwise less liquid than publicly traded securities. The illiquidity of our investments may make it difficult for us to sell such investments if the need arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we had previously recorded our investments. We may also face other restrictions on our ability to liquidate an investment in a portfolio company to the extent that we have material non-public information regarding such portfolio company.
We may experience fluctuations in our quarterly results.
We could experience fluctuations in our quarterly operating results due to a number of factors, including our ability to make investments in companies that meet our investment criteria, the interest rate payable on the debt securities we acquire, the level of our expenses, variations in and the timing of the recognition of realized and unrealized gains or losses, the degree to which we encounter competition in our markets, and general economic conditions. As a result of these factors, results for any period should not be relied upon as being indicative of performance in future periods.
Security breaches and other disruptions could compromise our information and expose us to liability, which would cause our business and reputation to suffer.
In the ordinary course of our business, we collect and store sensitive data, including our proprietary business information and that of our customers and personally identifiable information of our customers and employees, in our data centers, and on our networks. The secure processing, maintenance, and transmission of this information is critical to our operations. Despite our security measures, our information technology and infrastructure may be vulnerable to attacks by hackers or breached due to employee error, malfeasance or other disruptions. Any such breach could compromise our networks and the information stored there could be accessed, publicly disclosed, lost or stolen. Any such access, disclosure or other loss of information could result in legal claims or proceedings, liability under laws that protect the privacy of personal information and regulatory penalties, disrupt our operations and damage our reputation, which could adversely affect our business.
Terrorist attacks, other acts of violence or war, and natural disasters may affect any market for our securities, impact the businesses in which we invest, and harm our operations and profitability.
Terrorist attacks and natural disasters may harm our results of operations and your investment. We cannot assure you that there will not be further terrorist attacks against the US or US businesses or major natural disasters hitting the United States. Such attacks or natural disasters in the US or elsewhere may impact the businesses in which we directly or indirectly invest by undermining economic conditions in the United States. In addition, a substantial portion of our business is focused in the New York City metropolitan area, which suffered a terrorist attack in 2001. Another terrorist attack in New York City or elsewhere could severely impact our results of operations. Losses resulting from terrorist attacks are generally uninsurable.
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Our financial condition and results of operations will depend on our ability to manage growth effectively.
Our ability to achieve our investment objective will depend on our ability to grow, which will depend, in turn, on our management team’s ability to identify, evaluate, and monitor, and our ability to finance and invest in, companies that meet our investment criteria.
Accomplishing this result on a cost-effective basis will be largely a function of our management team’s handling of the investment process, its ability to provide competent, attentive, and efficient services, and our access to financing on acceptable terms. In addition to monitoring the performance of our existing investments, members of our management team and our investment professionals may also be called upon to provide managerial assistance to our portfolio companies. These demands on their time may distract them or slow the rate of investment. In order to grow, we will need to hire, train, supervise, and manage new employees. However, we cannot assure you that any such employees will contribute to the success of our business. Any failure to manage our future growth effectively could have a material adverse effect on our business, financial condition, and results of operations.
Our ability to enter into transactions with our affiliates is restricted.
The 1940 Act restricts our ability to knowingly participate in certain transactions with our affiliates. These restrictions limit our ability to buy or sell any security from or to our affiliates, or engage in “joint” transactions with our affiliates, which could include investments in the same portfolio company (whether at the same or different times). With respect to controlling or certain closely affiliated persons, we will generally be prohibited from engaging in such transactions absent the prior approval of the SEC. With respect to other affiliated persons, we may engage in such transactions only with the prior approval of our independent directors.
The SBA restricts the ability of SBICs to lend money to any of their officers, directors, and employees, or invest in any affiliates thereof.
Medallion Bank is subject to certain federal laws that restrict and control its ability to engage in transactions with its affiliates. Sections 23A and 23B of the Federal Reserve Act and applicable regulations restrict the transfer of funds by Medallion Bank to certain of its affiliates, including us, in the form of loans, extensions of credit, investments, or purchases of assets and restrict its ability to provide services to, or receive services from, its affiliates. Sections 23A and 23B also require generally that Medallion Bank’s transactions with its affiliates be on terms no less favorable to Medallion Bank than comparable transactions with unrelated third parties.
Our Board of Directors may change our operating policies and strategies without prior notice or shareholder approval, the effects of which may be adverse.
Our Board of Directors has the authority to modify or waive our current operating policies and strategies without prior notice and without shareholder 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, which could negatively impact our ability to pay you distributions and cause you to lose all or part of your investment.
Risks Relating to Our Investments
Lending to small businesses involves a high degree of risk and is highly speculative.
Lending to small businesses involves a high degree of business and financial risk, which can result in substantial losses and should be considered speculative. Our borrower base consists primarily of small business owners that may have limited resources and that are generally unable to obtain financing from traditional sources. There is generally no publicly available information about these small business owners, and we must rely on the diligence of our employees and agents to obtain information in connection with our credit decisions. In addition, these small businesses often do not have audited financial statements. Some smaller businesses have narrower product lines and market shares than their competition. Therefore, they may be more vulnerable to customer preferences, market conditions, or economic downturns, which may adversely affect the return on, or the recovery of, our investment in these businesses.
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Our portfolio is and may continue to be concentrated in a limited number of portfolio companies and industries and sectors, which will subject us to a risk of significant loss if any of these companies defaults on its obligations to us or by a downturn in the particular industry or sector.
Our portfolio is and may continue to be concentrated in a limited number of portfolio companies, industries and sectors. In addition, taxicab companies that constitute separate issuers may have related management or guarantors and constitute larger business relationships to us. As of September 30, 2017, investments in New York City taxi medallion loans represented approximately 78% of our managed taxi medallion loans, which in turn represented 28% of our managed net investment portfolio. We do not have fixed guidelines for diversification, and while we are not targeting any specific industries, our investments are, and could continue to be, concentrated in relatively few industries. As a result, the aggregate returns we realize may be adversely affected if a small number of investments perform poorly or if we need to write down the value of any one investment. If our larger borrowers were to significantly reduce their relationships with us and seek financing elsewhere, the size of our loan portfolio and operating results could decrease. In addition, larger business relationships may also impede our ability to immediately foreclose on a particular defaulted portfolio company as we may not want to impair an overall business relationship with either the portfolio company management or any related funding source. Additionally, a downturn in any particular industry or sector in which we are invested could also negatively impact the aggregate returns we realize.
If we are unable to continue to diversify geographically, our business may be adversely affected if the New York City taxicab industry experiences a sustained economic downturn.
A significant portion of our loan revenue is derived from medallion loans collateralized by New York City taxicab medallions. An economic downturn in the New York City taxicab industry could lead to an increase in defaults on our medallion loans. We cannot assure you that we will be able to sufficiently diversify our operations geographically.
An economic downturn could result in certain of our commercial and consumer loan customers experiencing declines in business activities and/or personal resources, which could lead to difficulties in their servicing of their loans with us, and increasing the level of delinquencies, defaults, and loan losses in our commercial and consumer loan portfolios.
Laws and regulations implemented in response to climate change could result in increased operating costs for our portfolio companies.
Congress and other governmental authorities have either considered or implemented various laws and regulations in response to climate change and the reduction of greenhouse gases. Existing environmental regulations could be revised or reinterpreted, new laws and regulations could be adopted, and future changes in environmental laws and regulations could occur, which could impose additional costs on the operation of our portfolio companies. For example, regulations to cut gasoline use and control greenhouse gas emissions from new cars could adversely affect our medallion portfolio companies. Our portfolio companies may have to make significant capital and other expenditures to comply with these laws and regulations. Changes in, or new, environmental restrictions may force our portfolio companies to incur significant expenses or expenses that may exceed their estimates. There can be no assurance that such companies would be able to recover all or any increased environmental costs from their customers or that their business, financial condition or results of operations would not be materially and adversely affected by such expenditures or any changes in environmental laws and regulations, in which case the value of these companies could be adversely affected.
Our portfolio companies may incur debt that ranks equally with, or senior to, our investments in such companies.
We invest in our portfolio companies primarily through senior secured loans, junior secured loans, and subordinated debt issued by small- to mid-sized companies. Our portfolio companies may have, or may be permitted to incur, other debt that ranks equally with, or senior to, the debt in which we invest. By their terms, such debt instruments may entitle the holders to receive payment of interest or principal on or before the dates on which we are entitled to receive payments with respect to the debt instruments in which we invest. Also, in the event of insolvency, liquidation, dissolution, reorganization, or bankruptcy of a portfolio company, holders of debt instruments ranking senior to our investment in that portfolio company would typically be entitled to receive payment in full before we receive any distribution. After repaying such senior creditors, such portfolio company may not have any remaining assets to use for repaying its obligation to us. In the case of debt ranking equally with debt instruments in which we invest, we would have to share on an equal basis any distributions with other creditors holding such debt in the event of an insolvency, liquidation, dissolution, reorganization, or bankruptcy of the relevant portfolio company.
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A third party finance company sold various participations in asset based loans to Medallion Business Credit and Medallion Bank. In April 2013, the aggregate balance of the participations was approximately $13.8 million, $12.9 million of which were held by Medallion Bank. That amount was divided between seven separate borrowers operating in a variety of industries. In April 2013, the third party finance company became the subject of an involuntary bankruptcy petition filed by its bank lenders. Among other things, the bank lenders alleged that the third party finance company fraudulently misrepresented its borrowing availability under its credit facility with the bank lenders and are seeking the third party finance company’s liquidation. In May 2013, the bankruptcy court presiding over the third party finance company’s case entered an order converting the involuntary Chapter 7 case to a Chapter 11 case. On May 31, 2013, we commenced an adverse proceeding against the third party finance company and the bank lenders seeking declaratory judgment that our loan participations are true participations and not subject to the bankruptcy estate or to the bank lender’s security interest in the third party finance company’s assets. The third party finance company and bank lenders are contesting our position. In April 2014, we received a decision from the court granting summary judgment in our favor with respect to the issue of whether our loan participations are true participations. In March 2015, we and Medallion Bank received a decision from the court finding that the bank lenders generally held a first lien on our and Medallion Bank’s loan participations subject to, among other things, defenses still pending prosecution by the parties and adjudication by the court. We and Medallion Bank are appealing the decision. The remaining issues are still being litigated. Although we believe the claims raised by the third party finance company and the senior lenders are without merit and will vigorously defend against them, we cannot at this time predict the outcome of this litigation or determine our potential exposure. If we are incorrect in our assessments our results of operations could be materially adversely affected. At September 30, 2017, five of the seven secured borrowers had refinanced their loans in full with third parties, and the related proceeds are held in escrow pending resolution of the bankruptcy proceedings. In September 2015, one loan was sold at a discount to a third party, and the related proceeds are held in escrow pending resolution of the bankruptcy proceedings. One loan was charged off in September 2014. See page 57 for additional information regarding this matter.
There may be circumstances where our debt investments could be subordinated to claims of other creditors or we could be subject to lender liability claims.
Even though we may have structured most of our investments as senior loans, if one of our portfolio companies were to go bankrupt, depending on the facts and circumstances, including the extent to which we actually provided managerial assistance to that portfolio company, a bankruptcy court might recharacterize our debt investment and subordinate all or a portion of our claim to that of other creditors. We may also be subject to lender liability claims for actions taken by us with respect to a borrower’s business or instances where we exercise control over the borrower. It is possible that we could become subject to a lender’s liability claim, including as a result of actions taken in rendering significant managerial assistance.
We may not control many of our portfolio companies.
We may not control many of our portfolio companies, even though we may have board representation or board observation rights, and our debt agreements may contain certain restrictive covenants. As a result, we are subject to the risk that a portfolio company in which we invest may make business decisions with which we disagree, and the management of such company may take risks or otherwise act in ways that do not serve our interests as debt investors.
We may not realize gains from our equity investments.
Certain investments that we have made in the past and may make in the future include warrants or other equity securities. In addition, we may from time to time make non-control, equity co-investments in companies in conjunction with private equity sponsors. Our goal is ultimately to realize gains upon our disposition of such equity interests. However, the equity interests we receive may not appreciate in value and, in fact, may decline in value. Accordingly, we may not be able to realize gains from our equity interests, and any gains that we do realize on the disposition of any equity interests may not be sufficient to offset any other losses we experience. We also may be unable to realize any value if a portfolio company does not have a liquidity event, such as a sale of the business, recapitalization, or public offering, which would allow us to sell the underlying equity interests.
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EXHIBITS
Number
Description
IMPORTANT INFORMATION RELATING TO FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements so long as those statements are identified as forward-looking and are accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those projected in such statements. In connection with certain forward-looking statements contained in this Form 10-Q and those that may be made in the future by or on behalf of the Company, the Company notes that there are various factors that could cause actual results to differ materially from those set forth in any such forward-looking statements. The forward-looking statements contained in this Form 10-Q were prepared by management and are qualified by, and subject to, significant business, economic, competitive, regulatory, and other uncertainties and contingencies, all of which are difficult or impossible to predict, and many of which are beyond the control of the Company. Accordingly, there can be no assurance that the forward-looking statements contained in this Form 10-Q will be realized or that actual results will not be significantly higher or lower. The statements have not been audited by, examined by, compiled by, or subjected to agreed-upon procedures by independent accountants, and no third-party has independently verified or reviewed such statements. Readers of this Form 10-Q should consider these facts in evaluating the information contained herein. In addition, the business and operations of the Company are subject to substantial risks which increase the uncertainty inherent in the forward-looking statements contained in this Form 10-Q. The inclusion of the forward-looking statements contained in this Form 10-Q should not be regarded as a representation by the Company or any other person that the forward-looking statements contained in this Form 10-Q will be achieved. In light of the foregoing, readers of this Form 10-Q are cautioned not to place undue reliance on the forward-looking statements contained herein. These risks and others that are detailed in this Form 10-Q and other documents that the Company files from time to time with the Securities and Exchange Commission, including annual reports on Form 10-K, quarterly reports on Form 10-Q, and any current reports on Form 8-Kmust be considered by any investor or potential investor in the Company.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ Alvin Murstein
/s/ Larry D. Hall
Senior Vice President and
Chief Financial Officer