Novation Companies, Inc. (NOVC)

FORM 10-K | Annual Report
Apr. 10, 2018 4:12 PM
|
About: Novation Companies, Inc. (NOVC)View as PDF
NOVATION COMPANIES, INC. (Form: 10-K, Received: 04/10/2018 16:15:17)
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 

FORM 10-K  
x
     
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
 
 
For the Fiscal Year Ended December 31, 2017

 
 
 
o
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period From __________to __________
 

Commission File Number 000-22897  
NOVATION COMPANIES, INC.
(Exact Name of Registrant as Specified in its Charter)  
Maryland
74-2830661
(State or Other Jurisdiction of Incorporation or Organization)
(I.R.S. Employer Identification No.)
 
 
500 Grand Boulevard, Suite 201B, Kansas City, MO
64106
(Address of Principal Executive Office)
(Zip Code)
 
Registrant’s Telephone Number, Including Area Code: (816) 237-7000
 
 
Securities Registered Pursuant to Section 12(b) of the Act:
None
  
Securities Registered Pursuant to Section 12(g) of the Act:
Title of Each Class
Common Stock, $0.01 par value
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined by Rule 405 of the Securities Act. Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
 
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 x No o
 
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 for such shorter period that the registrant was required to submit and post such files). Yes x No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, 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. Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company x Emerging growth company o
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. o

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No x
   
The aggregate market value of voting and non-voting stock held by non-affiliates of the registrant as of June 30, 2017 was approximately $8,117,000, based upon the closing sales price of the registrant’s common stock on that date ($0.14).

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes x No o
 
The number of shares of the registrant's common stock outstanding on April 9, 2018 was 96,007,321 .
 







NOVATION COMPANIES, INC.
FORM 10-K
For the Fiscal Year ended December 31, 2017
 

 
 
TABLE OF CONTENTS
 
 
 
PART I
 
 
 
 
 
Item 1.
Business
Item 1A.
Risk Factors
Item 1B.
Unresolved Staff Comments
Item 2.
Properties
Item 3.
Legal Proceedings
Item 4.
Mine Safety Disclosures
 
 
 
PART II
 
 
 
 
 
Item 5.
Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.
Selected Financial Data
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
Item 8.
Financial Statements and Supplementary Data
Item 9.
Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
Item 9A.
Controls and Procedures
Item 9B.
Other Information
 
 
 
PART III
 
 
 
 
 
Item 10.
Directors, Executive Officers and Corporate Governance
Item 11.
Executive Compensation
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions, and Director Independence
Item 14.
Principal Accountant Fees and Services
 
 
 
PART IV
 
 
 
 
 
Item 15.
Exhibits and Financial Statement Schedules
 
 
 
 
Exhibit Index
 
Signatures






PART I

Unless the context otherwise requires, references in this Annual Report on Form 10-K to “Novation,” the “Company,” “NOVC,” “we,” “us” and “our,” refer to Novation Companies, Inc. and its consolidated subsidiaries and their respective predecessors.

Forward-Looking Statements  
Statements in this report regarding Novation and its business that are not historical facts are “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Forward-looking statements are those that predict or describe future events, do not relate solely to historical matters and include statements regarding management's beliefs, estimates, projections, and assumptions with respect to, among other things, our future operations, business plans and strategies, as well as industry and market conditions, all of which are subject to change at any time without notice. Words such as “believe,” “expect,” “anticipate,” “promise,” “plan,” and other expressions or words of similar meanings, as well as future or conditional auxiliary verbs such as “would,” “should,” “could,” or “may” are generally intended to identify forward-looking statements. Risks, uncertainties, contingencies, and developments, including those discussed in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report could cause our future operating results to differ materially from those set forth in any forward-looking statement. Given these uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. We disclaim any obligation to update any such factors or to publicly announce the results of any revisions to any of the forward-looking statements contained herein to reflect future results, events or developments.

Item 1. Business

Overview

Through Healthcare Staffing, Inc. ("HCS"), our wholly-owned subsidiary acquired on July 27, 2017, we provide outsourced health care staffing and related services in the State of Georgia. We also own a portfolio of mortgage securities which generate earnings to support on-going financial obligations. Our common stock, par value $0.01 per share, is traded on the OTC Pink marketplace of the OTC Markets Group, Inc. under the symbol “NOVC”.

Recent Developments

Emergence from Bankruptcy . On July 20, 2016 (the “Bankruptcy Petition Date”), Novation and three of its subsidiaries, NovaStar Mortgage LLC (“NMLLC”), NovaStar Mortgage Funding Corporation and 2114 Central LLC (the “Debtors”), filed voluntary petitions (the “Bankruptcy Petitions”) for reorganization under Chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the District of Maryland (the “Bankruptcy Court”). The Company and one of its subsidiaries subsequently filed with the Bankruptcy Court and amended a plan of reorganization (the “Plan”) and a related disclosure statement. The Bankruptcy Court entered an order on June 12, 2017 confirming the Plan (the “Confirmation Order”) solely with respect to the Company. On July 27, 2017, upon the completion of the HCS Acquisition and the Note Refinancing (each as defined below), and the satisfaction or waiver of all other conditions precedent to effectiveness, the effective date of the Plan occurred and the Company filed a Notice of Occurrence of Effective Date of the Plan with the Bankruptcy Court. Under the Plan, holders of existing equity interests in the Company (i.e., the common stock) retain their interests.

On September 25, 2017, the bankruptcy case of 2114 Central, LLC was dismissed by order of the Bankruptcy Court.
Thereafter, on December 22, 2017, NMLLC filed with the Bankruptcy Court a Chapter 11 plan of reorganization, and on
December 26, 2017 filed a related disclosure statement. The Bankruptcy Court entered an order on February 16, 2018
approving the disclosure statement, as revised. The Bankruptcy Court will conduct a hearing on April 11, 2018 to consider
confirmation of NMLLC’s plan of reorganization.

Acquisition of Healthcare Staffing, Inc. On July 27, 2017, the Company acquired all of the outstanding capital stock of HCS from Butler America, LLC (“Butler”) for approximately $24.0 million in cash (the “HCS Acquisition”), pursuant to the terms and conditions of a Stock Purchase Agreement, dated as of February 1, 2017 (as amended, the “HCS Purchase Agreement”), by and among the Company, Novation Holding, Inc., a wholly-owned subsidiary of the Company (“NHI”), HCS and Butler. The purchase price is subject to adjustment as provided in the HCS Purchase Agreement. See Note 4 to the consolidated financial statements for additional information regarding the HCS Acquisition. The operations of HCS are the Company’s primary operations.

Note Refinancing. On July 27, 2017, the Company entered into a Senior Secured Note Purchase Agreement, dated as of the same date (the “Note Purchase Agreement”), with NHI and HCS as guarantors (together with the Company, collectively, the “Credit Parties”), Taberna Preferred Funding I, Ltd. (“Taberna I”), Taberna Preferred Funding II, Ltd. (“Taberna II”) and Kodiak CDO I, Ltd. (“Kodiak” and, together with Taberna I and Taberna II, the “Noteholders”) and Wilmington Savings Fund Society, FSB, as collateral agent for the benefit of the Noteholders, to refinance $85,937,500 of principal indebtedness of the Company under the Company’s senior notes (collectively, the “2011 Notes”) held by the Noteholders, issued pursuant to three Indentures, each dated as of March 22, 2011 (the “Note Refinancing”). Pursuant to the Note Purchase Agreement, the Noteholders exchanged their 2011 Notes for new notes from the Company in the same aggregate principal amount (collectively, the “2017 Notes”) on the terms and conditions set forth therein. The unpaid principal amounts of the 2017 Notes bear interest at a variable rate equal to LIBOR plus 3.5% per annum, payable quarterly in arrears until maturity on March 30, 2033. The 2017 Notes

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generally rank senior in right of payment to any existing or future subordinated indebtedness of the Credit Parties. See Notes 2 and 8 to the consolidated financial statements for additional information regarding the Note Refinancing.

Business

Our business includes the operation of HCS and the management of our other investments, as described below.

HCS

Established in 1995, HCS is the largest outsourced healthcare services provider in the State of Georgia. HCS delivers outsourced full-time and part-time employees primarily to Community Service Boards (“CSB”). A CSB is a quasi-state organization providing behavioral health services at facilities across Georgia including mental health services, developmental disabilities programs and substance abuse treatments. The State of Georgia has a total of 25 CSB. Each CSB has a number of facilities, including crisis centers, outpatient centers and 24-hour group homes that require a broad range of employees, such as registered nurses, social workers, house parents and supervisors. The CSB market in Georgia is large and growing steadily, as the demand for the services provided by the CSB continues to grow. The Georgia Association for CSB estimates that CSB in Georgia provided services to more than 173,000 people in 2010, a figure that grew to more than 188,000 people in 2016. In addition to providing outsourced employees to CSB, HCS also provides healthcare outsourcing and staffing services to hospitals, schools, crisis units, clinics, doctors offices, prisons and a variety of privately owned businesses.

Over the past 15 years, HCS has become the largest medical services outsource provider in Georgia, operating throughout the state. HCS has long-term relationships with its customers and has been providing services to several clients for more than 15 years. The services and positions provided to non-CSB clients are similar to the ones provided to CSB client.

Other Investments

Prior to 2016, the Company originated, purchased, securitized, sold, invested in and serviced residential nonconforming mortgage loans and mortgage securities. As a result of those activities, we acquired mortgage securities that continue to be a source of our earnings and cash flow. Residual securities consist of interest-only and overcollateralization bonds. Collectively, these securities are referred to as our retained mortgage securities.

Strategy
The strategy of HCS is to continue expanding its market share in providing healthcare staffing services in Georgia and in particular serving Georgia CSBs. HCS is the dominant player in providing services to Georgia CSBs and has earned a market share of 55% of the CSB business. HCS will also continue to expand business to additional hospitals, private group homes, clinics, rest homes, prisons and retirement centers. Furthermore, the HCS strategy includes expanding clerical staff within existing customers, as well as gaining new clients. The longer-term strategy includes expansion beyond the Georgia market and may include acquisitions of staffing companies outside of Georgia, particularly in states that have public health infrastructure similar to that of Georgia.

We expect to use profits from HCS along with, potentially, other funding sources to acquire other businesses or make investments.

Competition
HCS competes with numerous national staffing and recruiting businesses that specialize in the medical and healthcare industry, such as Nursefinders, Lighthouse Recruiting, Action Med and Brightstar. Other national staffing businesses have divisions that compete with HCS in Georgia, including Kelly Services, Interim, Randstad and Maxim. Numerous Georgia non-national and smaller staffing providers also compete with HCS.

Regulation
The healthcare industry is subject to extensive and complex federal, state and local laws and regulations related to, among
other things, conduct of operations, and costs and payment for services. HCS is not directly regulated as a healthcare provider,
although the customers of HCS are highly regulated. Therefore, HCS complies with many of the regulations prescribed for its
customers.

HCS provides services directly to its clients on a contract basis and receives payment directly from them. However, many clients are reimbursed under the federal Medicare program and state Medicaid programs for the services they provide. Therefore, HCS also may be affected indirectly by reimbursement changes in government programs, particularly Medicare and Medicaid.

Employees

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As of April 9, 2018 , the Company employed 1,798 full-time employees and 201 part-time employees. None of the Company's employees are represented by a union or covered by a collective bargaining agreement.

Additional Information

The Company is a Maryland corporation formed on September 13, 1996 as “CapStar Financial, Inc.” The Company’s name was changed to “NovaStar Financial, Inc.” effective October 11, 1996, and to “Novation Companies, Inc.” effective May 23, 2012. Our corporate executive offices are located at 500 Grand Boulevard, Suite 201B, Kansas City, MO 64106 and our telephone number is (816) 237-7000. Our website address is www.novationcompanies.com. Our website is not intended to be a part of, nor are we incorporating it by reference into, this Annual Report on Form 10-K (this "Form 10-K"). Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act are available, free of charge, on our website as soon as reasonably practicable after we electronically file this material with, or furnish it to, the SEC. Reports and other information we file with the SEC may also be viewed at the SEC’s website at www.sec.gov or viewed or obtained at the SEC Public Reference Room at 100 F Street, N.E., Washington, DC 20549.

Item 1A. Risk Factors

Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors, as well as the other information contained in this Form 10-K, including our consolidated financial statements and notes thereto, before deciding whether to invest in our common stock. Any of these risks, as well as additional risks and uncertainties that we are unaware of, could negatively affect our results of operations, financial condition, liquidity and business prospects, and cause the trading price of our common stock to decline, and cause you to lose all or part of your investment.

Risks Related to our Business and Industry

The healthcare industry is highly regulated.

The healthcare industry is subject to extensive and complex federal, state and local laws and regulations related to, among other things, conduct of operations, and costs and payment for services. While HCS is not directly regulated as a healthcare provider, the customers of HCS are highly regulated. Therefore, HCS must comply with many of the regulations prescribed for its customers. If HCS does not comply with applicable laws and regulations, it could incur civil and/or criminal penalties as well as litigation or be subject to equitable remedies. HCS may lose customers if it cannot adequately adhere to the regulations.

HCS provides services to hospitals and health systems that pay HCS directly. Accordingly, Medicare, Medicaid and insurance reimbursement policy changes generally do not directly impact HCS. However, HCS’s business, financial condition and results of operations depend upon conditions affecting the healthcare industry generally and hospitals and health systems particularly. The healthcare industry is highly regulated and is subject to changing political, economic and regulatory influences. Factors such as changes in reimbursement policies for healthcare expenses, consolidation in the healthcare industry, regulation, litigation and general economic conditions affect the purchasing practices, operations and the financial health of HCS’s customers.

Reimbursement changes in government programs, particularly Medicare and Medicaid, can and do indirectly affect the demand and the prices paid for HCS’s services. For example, HCS clients could receive reduced or no reimbursements because of a change in the rates or conditions set by the government, which would negatively affect the demand and the prices for HCS’s services.

The business of HCS is concentrated in the State of Georgia and to a relatively few number of customers.
HCS derives all of its revenues from clients in the State of Georgia. As a result, HCS is subject to risks associated with conditions in the State of Georgia, including but not limited to economic and regulatory risks, than healthcare staffing and other companies that are more geographically diversified.

HCS derives the majority of its businesses from CSBs. There are 25 CSBs in Georgia and HCS conducts business with 14 of them. Matters that adversely impact Georgia CSBs, including regulatory changes, may negatively affect our business.

Our clients may terminate or not renew their contracts with us.

Our arrangements with CSBs and other customers generally are terminable upon 60 days’ notice for any reason. The loss of one or more of our large customers could materially affect our profitability.

We may be unable to recruit enough healthcare professionals to meet our clients’ demands.

HCS relies significantly on its ability to attract, develop and retain healthcare professionals who possess the skills, experience and, as required, licensure necessary to meet the specified requirements of our healthcare clients. The ability to recruit

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healthcare professionals generally and the competition for their services may limit our ability to increase the number of healthcare professionals that we successfully recruit, decreasing our ability to grow our business.

We are subject to litigation in the ordinary course of business, which could result in substantial judgment or settlement costs; significant legal actions could subject us to substantial uninsured liabilities.

HCS is a party to various litigation claims and legal proceedings in its normal course of business. We evaluate these litigation claims and legal proceedings to assess the likelihood of unfavorable outcomes and to estimate, if possible, the amount of potential losses. We may not have sufficient insurance to cover these risks. Actual outcomes or losses may differ materially from those estimated by our current assessments which would impact our profitability. Adverse developments in existing litigation claims or legal proceedings involving HCS or new claims could require us to establish litigation reserves, enter into unfavorable settlements or satisfy judgments for monetary damages for amounts in excess of current reserves, which could adversely affect our financial results. We may not have sufficient insurance to cover these risks. Litigation losses would impact our profitability.

Our collection, use, and retention of personal information and personal health information create risks that may harm our business.

As part of its business model, HCS collects, transmits and retains personal information of our employees and contract professionals and their dependents, including, without limitation, full names, social security numbers, addresses, birth dates, and payroll-related information. Employees or third parties may be able to circumvent security measures in place and acquire or misuse such information, resulting in breaches of privacy, and errors in the storage, use or transmission of such information may result in breaches of privacy. We may be required to incur significant expenses to comply with mandatory privacy and security standards and protocols imposed by law, regulation, industry standards, or contractual obligations if a privacy breach were to occur.

Cyber security risks and cyber incidents could adversely affect our business and disrupt operations.

Cyber incidents can result from deliberate attacks or unintentional events. These incidents can include, but are not limited to, gaining unauthorized access to digital systems for purposes of misappropriating assets or sensitive information, corrupting data, or causing operational disruption. The result of these incidents could include, but are not limited to, disrupted operations, misstated financial data, liability for stolen assets or information, increased cyber security protection costs, litigation and reputational damage adversely affecting customer or investor confidence. Security measures in place may not provide absolute security, and systems may be vulnerable to cyber-security breaches such as viruses, hacking, and similar disruptions from unauthorized intrusions. In addition, third party service providers perform certain services, such as payroll and tax services. Any failure of HCS or third party systems may compromise sensitive information and/or personally identifiable information of employees.


Risks Related to our Company

We have a history of operating losses and we may not generate sufficient revenue to support our operations.

During 2017, we incurred a net loss of $10.9 million and generated negative operating cashflow of $8.7 million . As of December 31, 2017, we had an overall shareholders deficit of $57.9 million . As of December 31, 2017, we had an aggregate of $2.7 million in cash and cash equivalents and total liabilities of $97.7 million . Of the $2.7 million in cash, $1.1 million was held by our subsidiary NMLLC, which has filed a Chapter 11 plan of reorganization that remains subject to court approval. This cash is not available to pay general creditors of NMLLC. The Company also has a significant on-going obligation to pay interest under its senior note agreement. In addition, beginning in 2018 a significant customer significantly reduced the level of staff outsourced to HCS.

At the time of the Company's filing of its Quarterly Report on Form 10-Q for the quarter ended September 30, 2017, management concluded that substantial doubt existed about the Company's ability to continue as a going concern within one year after the date that the consolidated financial statements were issued. Management’s assessment was based on the expected negative impact on cash flow related to the loss of a significant customer of HCS. In addition, management was unsure of its ability to generate cash flow through other means, such as selling the Company's marketable securities at acceptable prices and uncertainty as to whether the Company could efficiently transfer the securities and receive cash proceeds in order to meet obligations as they come due.

Subsequent to that filing and subsequent to year end, the Company engaged a major investment firm to evaluate the marketplace for its mortgage securities. Management learned during that process that a market exists for the Company’s mortgage securities and that those securities may be sold at prices acceptable to the Company. The Company executed trades to sell a portion of its overcollateralization mortgage securities. These sales are expected to generate $2.9 million in cash proceeds for the Company. Management believes that other mortgage securities may be sold on similar terms in the event additional cash proceeds are needed. In addition, through the date of this filing, HCS has demonstrated that it can provide

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positive cash flow sufficient to support HCS operations. Management continues to work toward expanding HCS’s customer base by increasing revenue from existing customers and targeting new customers that have not previously been served by HCS. In addition, management is exploring cost cutting initiatives that will reduce overall corporate overhead and operating costs.

While our historical operating results and poor cashflow suggest substantial doubt exists related to the Company’s ability to continue as a going concern, management has concluded that the factors discussed above have alleviated the substantial doubt about the Company's ability to continue as a going concern within one year after the date that these consolidated financial statements are issued.

We cannot provide assurance that revenue generated from our businesses will be sufficient to sustain our operations in the long term. Additionally, we cannot be certain that we will be successful at raising capital, whether from divesting of mortgage securities or other assets, or from equity or debt financing, on commercially reasonable terms, if at all. Such failures would have a material adverse effect on our business, including the possible cessation of operations.

We found material weaknesses in our disclosure controls and procedures and internal control over financial reporting and concluded that they were not effective as of December 31, 2017.

As disclosed in Part II, Item 9. Controls and Procedures of this Form 10-K, our executive chairman and chief financial officer, with the participation of the Company’s management, concluded that our disclosure controls and procedures and internal controls over financial reporting were not effective as of December 31, 2017 due to the lack of adequate processes, procedures and controls at HCS. Our failure to successfully remediate these material weaknesses could cause us to fail to meet our reporting obligations and to produce timely and reliable financial information. Additionally, such failure could cause investors to lose confidence in our public disclosures, which could have a negative impact on our stock price. For a discussion of these material weaknesses and our remediation efforts, please see Part II, Item 9. Controls and Procedures of this Form 10-K.

Our ability to use our net operating loss carryforwards and net unrealized built-in losses could be severely limited.

As of December 31, 2017, we had federal net operating losses ("NOLs") of approximately $692.0 million , including $307.3 million in losses on mortgage securities that have not been recognized for income tax purposes. Our ability to use NOLs to offset future taxable income will depend on the amount of taxable income we generate in future periods and whether we become subject to annual limitations on the amount of taxable income that may be offset by our NOLs.

Section 382 of the Internal Revenue Code of 1986, as amended (the “Code”), imposes an annual limitation on the amount of taxable income that may be offset by a corporation’s NOLs if the corporation experiences an “ownership change” as defined in Section 382 of the Code. An ownership change occurs when the corporation’s “5-percent shareholders” (as defined in Section 382 of the Code) collectively increase their ownership in the corporation by more than 50 percentage points (by value) over a rolling three-year period. Additionally, various states have similar limitations on the use of state NOLs following an ownership change.

Our charter includes provisions designed to protect the tax benefits of our NOLs by generally restricting any direct or indirect transfers of our common stock that increase the direct or indirect ownership of our common stock by any person from less than 4.99% to 4.99% or more, or increase the percentage of our common stock owned directly or indirectly by a person owning or deemed to own 4.99% or more of our common stock. Any direct or indirect transfer attempted in violation of these transfer restrictions will be void as of the date of the prohibited transfer as to the purported transferee. These transfer restrictions expire on August 1, 2020. Additionally, we have adopted and our shareholders have approved a Rights Agreement (the “NOL Rights Plan”) that generally is designed to deter any person from acquiring shares of our common stock if the acquisition would result in such person beneficially owning 4.99% or more of our common stock without the approval of our Board of Directors (the “Board”). Our NOL Rights Plan expires on July 23, 2018. We intend to ask the shareholders to vote to extend the NOL Rights Plan at the Company's next annual meeting of shareholders.

Although these measures are intended to reduce the likelihood of an ownership change, we cannot assure you that they will prevent all transfers of our common stock that could result in such an ownership change. Further, these measures could make it more difficult for a third party to acquire, or could discourage a third party from acquiring, the Company or a large block of our common stock, which may adversely affect the marketability, and depress the market price, of our common stock. In addition, these provisions could delay or frustrate the removal of incumbent directors and could make more difficult a merger, tender offer or proxy contest involving us, or impede an attempt to acquire a significant or controlling interest in us, even if such events might be beneficial to us and our shareholders.

On December 22, 2017, the President signed into law the Tax Cuts and Jobs Act (“2017 Tax Act”), which contains substantial changes to the Code. The 2017 Tax Act, among other things, reduces the federal corporate tax rate from a top marginal rate of 35% to a flat rate of 21%, limits the tax deduction for interest expense to 30% of adjusted earnings, eliminates NOL carrybacks, limits the deductibility of loss carryforwards to 80% of current-year taxable income, and modifies or repeals many business deductions and credits. The tax rate reduction took effect on January 1, 2018. The lower tax rate and other new limits on the recognition of tax loss carryforwards have also reduced the value of existing NOL carryforwards and other tax assets. See Note 12 to our consolidated financial statements. There was no net effect of the tax reform enactment on the consolidated financial

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statements as of December 31, 2017. Notwithstanding the reduction in the corporate income tax rate, the overall impact of the Tax Act is uncertain and our business and financial condition could be adversely affected. We continue to examine the impact these changes may have on our deferred tax assets and our business.

Covenant restrictions under our indebtedness may limit our ability to operate our business.

The agreement governing the 2017 Notes contains, among other things, covenants that may restrict our and our subsidiaries' ability to finance future operations, capital needs or to engage in other business activities. The Note Purchase Agreement and the 2017 Notes limit our ability and the ability of our subsidiaries to take certain actions without the consent of the Noteholders, including but not limited to the following:
incur indebtedness;
create certain liens;
make payments to our shareholders;
acquire our outstanding shares, or the shares of our subsidiaries;
make payments on debt securities junior to the 2017 Notes; and
merge, consolidate, transfer and/or sell substantially all of our assets.

There can be no assurance that we will be able to receive the consent of the Noteholders should we have a need to take one of the restricted actions, which limitation may hinder our ability to operate or grow our business in the future.

Loss of key members of our management could disrupt our business.

The loss of key members of management could have a material adverse effect on our business, financial condition and results of operations. We may not be able to retain our existing senior management, fill new positions or vacancies created by expansion or turnover or attract additional qualified senior management personnel.

Differences in our actual experience compared to the assumptions that we use to determine the value of our residual mortgage securities and to estimate fair values could further adversely affect our financial position.

The Company uses significant unobservable inputs (Level 3 inputs) to estimate the fair value of its residual mortgage securities. Material differences between actual experience and the assumptions used to determine the fair value of these securities may negatively impact our financial condition and results of operations. For example, one significant unobservable input used to determine the fair value of the Company's residual mortgage securities is the prepayment rate for the underlying mortgage loan collateral. If prepayment rates are faster (higher) than our estimates, the value of the securities may decline significantly.

The cash flows from, and value of, our mortgage securities will further decline as the underlying mortgage loan collateral declines.

There are many factors that affect the cash flows from, and value of, our mortgage securities, many of which are beyond our control. In general, the nature of mortgage securities is that as the underlying mortgage loan collateral is repaid or defaults, the cash flows from, and value of, our securities will decline.

We may be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of breaches of representations and warranties, borrower fraud, or certain borrower defaults, which could further harm our liquidity.

When we sold mortgage loans, whether as whole loans or pursuant to a securitization, we made customary representations and warranties to the purchaser about the mortgage loans and the manner in which they were originated. Our whole loan sale agreements require us to repurchase or substitute mortgage loans in the event we breach any of these representations or warranties. In addition, we may be required to repurchase mortgage loans as a result of borrower, broker, or employee fraud. Likewise, we are required to repurchase or substitute mortgage loans if we breach a representation or warranty in connection with our securitizations. We have received various repurchase demands as performance of subprime mortgage loans has deteriorated. A majority of repurchase requests have been denied, otherwise a negotiated purchase price adjustment was agreed upon with the purchaser. Enforcement of repurchase obligations against us would further harm our liquidity.

Risks Related to our Capital Stock

There can be no assurance that our common stock will continue to be traded in an active market.

Our common stock currently trades on the OTC Pink marketplace of the OTC Markets Group, Inc. Trading of securities on this quotation service is generally limited and is effected on a less regular basis than on exchanges, such as the NYSE, and accordingly investors who own or purchase our stock will find that the liquidity or transferability of the stock may be limited. Additionally, a shareholder may find it more difficult to dispose of, or obtain accurate quotations as to the market value of, our stock. If an active public trading market cannot be sustained, the trading price of our common stock could be adversely affected and the ability of an investor to transfer their shares of our common stock may be limited.


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The market price and trading volume of our common stock may be volatile, which could result in substantial losses for our shareholders.

The market price of our capital stock can be highly volatile and subject to wide fluctuations. In addition, the trading volume in our capital stock may fluctuate and cause significant price variations to occur. Investors may experience volatile returns and material losses. Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our capital stock include:
actual or anticipated changes in our earnings and cash flow;
general market and economic conditions, including the operations and stock performance of other industry participants;
the impact of new state or federal legislation or adverse court decisions;
actual or anticipated changes in the delinquency and default rates on mortgage loans, in general, and specifically on the loans we invest in through our mortgage securities;
actual or anticipated changes in financial estimates by securities analysts;
sales, or the perception that sales could occur, of a substantial number of shares of our common stock by insiders;
additions or departures of senior management and key personnel; and
actions by institutional shareholders.

Some provisions of our charter, bylaws, Maryland law and our NOL Rights Plan may deter takeover attempts, which may limit the opportunity of our shareholders to sell their common stock at favorable prices.

Certain provisions of our charter, bylaws, Maryland law, and our NOL Rights Plan could discourage, delay or prevent transactions that involve an actual or threatened change in control, and may make it more difficult for a third party to acquire us, even if doing so may be beneficial to our shareholders. Under our charter, generally a director may only be removed for cause and only by the affirmative vote of the holders of at least a majority of all classes of shares entitled to vote in the election for directors together as a single class. Maryland law provides protection for Maryland corporations against unsolicited takeover situations. Further, our charter includes provisions designed to protect the tax benefits of our NOLs by generally restricting any direct or indirect transfers of our common stock that increase the direct or indirect ownership of our common stock by any person from less than 4.99% to 4.99% or more, or increase the percentage of our common stock owned directly or indirectly by a person owning or deemed to own 4.99% or more of our common stock. Any direct or indirect transfer attempted in violation of these transfer restrictions will be void as of the date of the prohibited transfer as to the purported transferee. These transfer restrictions expire on August 1, 2020. Additionally, we have adopted an NOL Rights Plan that generally is designed to deter any person from acquiring shares of our common stock if the acquisition would result in such person beneficially owning 4.99% or more of our common stock without the approval of our Board. Our NOL Rights Plan expires on July 23, 2018. We intend to ask the shareholders to vote to extend the NOL Rights Plan at the Company's next annual meeting of shareholders.

Item 1B. Unresolved Staff Comments
 
None.


Item 2. Properties
 
The executive and administrative offices for the Company are located in Kansas City, Missouri, and consist of approximately 2,300 square feet of leased office space. HCS leases office space in a number of locations in the state of Georgia. The executive and administrative offices for HCS are located in College Park, Georgia, and consist of approximately 4,700 square feet of leased office space.

Item 3. Legal Proceedings
 
The Company is a party to various legal proceedings. Except as set forth below, these proceedings are of an ordinary and routine nature.

On May 21, 2008, a purported class action case was filed in the Supreme Court of the State of New York, New York County, by the New Jersey Carpenters' Health Fund, on behalf of itself and all others similarly situated. Defendants in the case included NovaStar Mortgage Funding Corporation (“NMFC”) and NovaStar Mortgage, Inc. ("NMI"), wholly-owned subsidiaries of the Company, and NMFC's individual directors, several securitization trusts sponsored by the Company (“affiliated defendants”) and several unaffiliated investment banks and credit rating agencies. The case was removed to the United States District Court for the Southern District of New York. On June 16, 2009, the plaintiff filed an amended complaint. The plaintiff seeks monetary damages, alleging that the defendants violated sections 11, 12 and 15 of the Securities Act of 1933, as amended, by making allegedly false statements regarding mortgage loans that served as collateral for securities purchased by the plaintiff and the purported class members. On August 31, 2009, the Company filed a motion to dismiss the plaintiff's claims, which the court granted on March 31, 2011, with leave to amend. The plaintiff filed a second amended complaint on May 16, 2011, and the Company again filed a motion to dismiss. On March 29, 2012, the court dismissed the plaintiff's second amended complaint with prejudice and without leave to replead. The plaintiff filed an appeal. On March 1, 2013, the appellate court reversed the judgment of the lower court, which had dismissed the case. Also, the appellate court vacated the judgment of the lower court which had

7



held that the plaintiff lacked standing, even as a class representative, to sue on behalf of investors in securities in which plaintiff had not invested, and the appellate court remanded the case back to the lower court for further proceedings. On April 23, 2013 the plaintiff filed its memorandum with the lower court seeking a reconsideration of the earlier dismissal of plaintiff's claims as to five offerings in which plaintiff was not invested, and on February 5, 2015 the lower court granted plaintiff's motion for reconsideration and vacated its earlier dismissal. On March 8, 2017, the affiliated defendants and all other parties executed an agreement to settle the action, with the contribution of the affiliated defendants to the settlement fund being paid by their insurance carriers. The court certified a settlement class and granted preliminary approval to the settlement on May 10, 2017.  One member of the settlement class objected to the settlement and sought a stay of the final settlement approval hearing on the ground that it did not receive notice of the settlement and had no opportunity to timely opt out of the class.  After the court rejected the motion for a stay, the objector filed an appeal and requested a stay of the district court proceedings pending disposition of the appeal. The court of appeals denied the temporary stay of the district court proceedings pending a decision on the objector’s request for a stay. Assuming the settlement is approved and completed, the Company will incur no loss. The Company believes that the affiliated defendants have meritorious defenses to the case and, if the settlement is not approved, expects them to defend the case vigorously.

On June 20, 2011, the National Credit Union Administration Board, as liquidating agent of U.S. Central Federal Credit Union, filed an action against NMFC and numerous other defendants in the United States District Court for the District of Kansas, claiming that the defendants issued or underwrote residential mortgage-backed securities pursuant to allegedly false or misleading registration statements, prospectuses, and/or prospectus supplements. On August 24, 2012, the plaintiff filed an amended complaint making essentially the same claims against NMFC. NMFC filed a motion to dismiss the amended complaint which was denied on September 12, 2013. The defendants had claimed that the case should be dismissed based upon a statute of limitations and sought an appeal of the court's denial of this defense. An interlocutory appeal of this issue was allowed, and on August 27, 2013, the Tenth Circuit affirmed the lower court’s denial of defendants’ motion to dismiss the plaintiff’s claims as being time barred; the appellate court held that the Extender Statute, 12 U.S.C. §1787(b)(14) applied to plaintiff’s claims. On June 16, 2014, the United States Supreme Court granted a petition of NMFC and its co-defendants for certiorari, vacated the ruling of the Tenth Circuit, and remanded the case back to that court for further consideration in light of the Supreme Court’s decision in CTS Corp. v. Waldburger, 134 S. Ct. 2175 (2014). On August 19, 2014, the Tenth Circuit reaffirmed its prior decision, and on October 2, 2014 the defendants filed a petition for writ of certiorari with the Supreme Court, which was denied. On March 22, 2016, NMFC filed motions for summary judgment, and plaintiff filed a motion for partial summary judgment. Those motions remain pending. Given that plaintiff did not file a timely proof of claim in NMFC’s bankruptcy case, the Company believes it is likely that the case will be dismissed. The Company believes that NMFC has meritorious defenses to the case and expects it to defend the case vigorously in the event it proceeds.

On February 28, 2013 the Federal Housing Finance Agency, as conservator for the Federal Home Loan Mortgage Corporation (Freddie Mac) and purportedly on behalf of the Trustee of the NovaStar Mortgage Funding Trust, Series 2007-1 (the “Trust”), a securitization trust in which the Company retains a residual interest, filed a summons with notice in the Supreme Court of the State of New York, County of New York against the Company and NMI. The notice provides that this is a breach of contract action with respect to certain, unspecified mortgage loans and defendants' failure to repurchase such loans under the applicable agreements. Plaintiff alleges that defendants, from the closing date of the transaction that created the Trust, were aware of the breach of the representations and warranties made and failed to give notice of and cure such breaches, and due to the failure of defendants to cure any breach, notice to defendants would have been futile. The summons with notice was not served until June 28, 2013. By letter dated June 24, 2013, the Trustee of the Trust forwarded a notice from Freddie Mac alleging breaches of representations and warranties with respect to 43 loans, as more fully set forth in included documentation. The 43 loans had an aggregate, original principal balance of about $6.5 million. On August 19, 2013, Deutsche Bank National Trust Company, as Trustee, filed a complaint identifying alleged breaches of representations and warranties with respect to seven loans that were included in the earlier list of 43 loans. Plaintiff also generally alleged a trust-wide breach of representations and warranties by defendants with respect to loans sold and transferred to the trust. Plaintiff seeks specific performance of repurchase obligations; compensatory, consequential, recessionary and equitable damages for breach of contract; specific performance and damages for anticipatory breach of contract; indemnification (indemnification against NMI only) and damages for breach of the implied covenant of good faith and fair dealing. On October 9, 2013, the Company and NMI filed a motion to dismiss plaintiff’s complaint. This motion to dismiss was withdrawn after plaintiff filed an amended complaint on January 28, 2014, and on March 4, 2014 the Company and NMI filed a motion to dismiss the amended complaint. By a Decision/Order dated November 30, 2017, the court granted in part and denied in part the motion to dismiss the amended complaint. The court dismissed all claims except for plaintiff’s claim for damages for breach of contract, to the extent that claim is based on the Company’s and NMI’s alleged failure to notify plaintiff of allegedly defective loans, and plaintiff’s claim for indemnification. The court denied the motion to dismiss these claims without prejudice to the Company’s and NMI’s right to file a new motion to dismiss in conformity with procedures to be established in coordinated proceedings before the court addressing similar claims against numerous defendants. Briefing of the indemnification issue is now underway. Given the stage of the litigation, the Company cannot provide an estimate of the range of any loss. The Company has meritorious defenses to the case and expects to defend the case vigorously.

See "Reorganization" in Part I, Item 1. Business of the Form 10-K and Note 2 to the consolidated financial statements for a description of the Chapter 11 cases of Novation and the other Debtors.

Item 4. Mine Safety Disclosures


8



None.

9





PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
The Company's common stock currently trades on the OTC Pink marketplace of the OTC Markets Group, Inc. under the symbol “NOVC”. Prior to the commencement of the Company's Chapter 11 case, the Company's common stock traded on the OTCQB market of the OTC Markets Group, Inc. under the symbol "NOVC." The following table sets forth the high and low bid prices as reported by these quotation services, for the periods indicated.
 
 
 
 
 
 
 
 
High
 
Low
2017
 
 
 
 
First Quarter
 
$
0.18

 
$
0.03

Second Quarter
 
0.23

 
0.12

Third Quarter
 
0.14

 
0.09

Fourth Quarter
 
0.12

 
0.06

 
 
 
 
 
2016
 
 
 
 
First Quarter
 
$
0.14

 
$
0.05

Second Quarter
 
0.10

 
0.06

Third Quarter
 
0.08

 
0.03

Fourth Quarter
 
0.06

 
0.03

 
 
 
 
 

As of April 9, 2018 , we had approximately 705 shareholders of record of the Company's common stock. This figure does not represent the actual number of beneficial owners of our common stock because such stock is frequently held in "street name" by securities dealers and others for the benefit of individual owners who may vote the shares.

No dividends were declared during 2017 or 2016 nor do we expect to declare any stock dividend distributions in the near future.The Note Purchase Agreement governing the Company's senior notes contains restrictive covenants which prohibit the Company and its subsidiaries, from among other things, making any cash dividend or distribution to Novation shareholders. Should the restrictions be relieved, any future determination to pay dividends will be made at the discretion of our Board and will depend on earnings, financial condition, cost of equity, investment opportunities and other factors as our Board may deem relevant.

Item 6. Selected Financial Data
 
Not applicable.

10




Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
The following is a discussion and analysis of our financial condition and results of operations for the years ended December 31, 2017 and 2016. This discussion and analysis should be read in conjunction with our audited consolidated financial statements and Notes to the Consolidated Financial Statements set forth in Part II, Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.

Corporate Overview
Through our wholly-owned subsidiary HCS, acquired on July 27, 2017, we provide outsourced health care staffing and related services in the State of Georgia. We also own a portfolio of mortgage securities which generate earnings to support on-going financial obligations. Our common stock, par value $0.01 per share, is traded on the OTC Pink marketplace of the OTC Markets Group, Inc. under the symbol “NOVC”.

See Part I, Item 1 of this Form 10-K for a discussion of recent events, including the completion of the HCS Acquisition and the Note Refinancing, and the effectiveness of the Plan on July 27, 2017.

Financial Highlights and Key Performance Metrics. The following key performance metrics (in thousands, except per share
amounts) are derived from our consolidated financial statements for the periods presented and should be read in conjunction with the more detailed information therein and with the disclosure included in this report under the heading “Management's Discussion and Analysis of Financial Condition and Results of Operations.”
 
 
December 31,
 
 
2017
 
2016
Cash and cash equivalents
 
$
2,740

 
$
4,805

Marketable securities
 
$
11,795

 
$
36,488

Net income (loss) available to common shareholders, per basic and diluted share
 
$
(0.12
)
 
$
0.06


  
Consolidated Results of Operations
Year ended December 31, 2017 as Compared to the Year Ended December 31, 2016
Service Fee Income and Cost of Services
HCS delivers outsourced full-time and part-time employees primarily to Community Service Boards (“CSBs”), quasi state organizations that provide behavioral health services at facilities across Georgia including mental health services, developmental disabilities programs and substance abuse treatments. The State of Georgia has a total of 25 CSBs. Each CSB has a number of facilities, including crisis centers, outpatient centers and 24-hour group homes that require a broad range of employees, such as registered nurses, social workers, house parents and supervisors. The CSB market in Georgia is large and growing steadily, as the demand for the services provided by the CSBs continues to grow. In addition to providing outsourced employees to CSBs, HCS also provides healthcare outsourcing and staffing services to hospitals, schools and a variety of privately owned businesses. The services and positions provided to non CSB clients are similar to the ones provided to CSB clients. The service fee income and costs of services in the consolidated statement of operations and comprehensive income (loss) during 2017 are from the operations of HCS.

Future service fee income will be driven by the number customers and the volume of associates employed by the CSB and outsourced to HCS. Customer contracts typically establish a fixed markup on the pay rate for the associates; therefore the cost of services will generally fluctuate consistently with fee income. HCS offers a health and welfare benefit plan to its associates. The cost of this benefit is passed through to customers plus a small markup to cover cost of administration.

During the fourth quarter of 2017, HCS was notified that a customer would be significantly reducing the level of staff outsourced to HCS. The last pay period in 2017 was the final service period for these employees. This customer represented more than 20% of the Company's service fee income during 2017. While HCS has increased revenue from other sources and expects to continue adding new customers and adding revenue from existing customers, the Company does not expect to fully replace the lost revenue in the near term.

General and Administrative Expenses
General and administrative expenses consist of salaries, office costs, legal and professional expenses and other customary costs of corporate administration. The large increase in these expenses during 2017 results from the HCS Acquisition and the combination of HCS's expenses with those of Novation. During 2017, $2.8 million of the total general and administrative expenses were incurred by HCS. Corporate-level general and administrative expenses during 2017 and 2016 were $3.9 million and $4.4 million, respectively. The costs associated with the HCS Acquisition was the primary reason for the increase in corporate-level general and administrative expenses.

11




The future amount of corporate-level general and administrative expenses will depend largely on corporate activities, professional fees associated with those activities and staffing needs based on the evolving business strategy. For HCS, the amount of these expenses will depend on business growth.

Goodwill Impairment Charge

As discussed above, during the fourth quarter of 2017, HCS was notified that a customer would be significantly reducing the level of staff outsourced to HCS. The last pay period in 2017 was the final service period for these employees. Accordingly, management completed a goodwill impairment assessment as of December 31, 2017, which determined that the carrying value of the HCS goodwill exceeded the fair value by $4.5 million .

Interest Income – Mortgage Securities

Interest income on our mortgage securities decreased to approximately $3.1 million in 2017 from $5.1 million in 2016 . Fluctuations in the interest income received from our mortgage portfolio are typically due to factors beyond the Company's control, such as the performance of the underlying loan collateral, prepayment speeds, interest rates, etc. The Company expects interest income and cash flow from these securities to decline as the principal on the underlying loan collateral is paid, written down, or written off. However, the Company owns overcollateralization ("OC") mortgage securities that are expected to generate cash flow. These securities represent the excess of securitized mortgage loan collateral over mortgage bonds sold to third parties. When the third party bonds are fully repaid, the mortgage loan principal and interest payments will be paid to the Company as the owner of the OC bonds. The timing of receipt of these payments is unknown and depends on the timing of the mortgage loan principal and interest payments.

Other Income
The Company uses available cash to acquire various equity and fixed income securities as part of its strategy to generate taxable earnings. Other income consists primarily of the interest, dividend, and other income received from these securities. Fluctuations in the income received from these securities results from the timing of purchases/sales and amounts of dividends and interest paid. Subsequent to the HCS Acquisition, the Company has significantly less available funds to invest. Therefore, for the foreseeable future, income related to investments is expected to be significantly lower than has been demonstrated through December 31, 2017.
 
 
For the Year Ended December 31,
 
 
2017
 
2016
Dividends and interest income
 
$
230

 
$
1,741

Gains on sales of investments
 
137

 
3,672

Other
 
(19
)
 
59

 
 
 
 
 
Total
 
$
348

 
$
5,472



Reorganization items, net
The Company has incurred significant costs associated with our reorganization and the Chapter 11 proceedings, which are being expensed as incurred. In addition, during 2016, a non-cash charge to write-off the unamortized debt issuance costs related to our 2011 Notes is included in “Reorganization items, net” as these debt instruments are expected to be impacted by the bankruptcy reorganization process. Reorganization items include (in thousands):
 
For the Year Ended December 31,
 
2017
 
2016
Adjustments to deferred debt issuance costs and senior debt premium
$

 
$
2,399

Professional fees
(3,460
)
 
(1,252
)
Adjustments to other liabilities for claims made or rejected contracts
(87
)
 
(449
)
Other
(34
)
 
(31
)
Reorganization items, net
$
(3,581
)
 
$
667


12




We expect these costs to decline significantly in 2018.

Interest Expense

Interest expense is comprised primarily of interest on our senior notes, which is variable based on 3-month LIBOR. Interest expense increased to $3.9 million in 2017 from $3.6 million in 2016 . The increase in interest expense is a result of an increase in LIBOR.

Liquidity and Capital Resources
During 2017, the Company incurred a net loss of $10.9 million and generated negative operating cash flow of $ 8.7 million . As of December 31, 2017 the Company has an overall shareholders deficit of $ 57.9 million . As of December 31, 2017, the Company had an aggregate of $2.7 million in cash and cash equivalents and total liabilities of $97.7 million . Of the $2.7 million in cash, $1.1 million is held by the Company's subsidiary NMLLC, which has filed a Chapter 11 plan of reorganization that remains subject to court approval. This cash is available to pay general creditors and expenses of NMLLC. The Company also has a significant on-going obligation to pay interest under its senior note agreement. In addition, beginning in 2018 a significant customer significantly reduced the level of staff outsourced to HCS.

On November 17, 2017, HCS entered into a Revolving Credit and Security Agreement, dated as of the same date (the “FNCC
Credit Agreement”), with Federal National Payables, Inc. (d/b/a Federal National Commercial Credit) (“FNCC”) providing HCS
with a line of credit of up to $5,000,000. Availability under the FNCC Credit Agreement is based on a formula tied to HCS’s
eligible accounts receivable, and borrowings under the FNCC Credit Agreement bear interest at the prime rate plus 1.25%. The
FNCC Credit Agreement also provides for customary origination and collateral monitoring fees payable to FNCC during its term.
The initial term of the FNCC Credit Agreement expires on November 17, 2018, but it will be renewed automatically for
consecutive one-year terms thereafter unless the FNCC Credit Agreement is terminated pursuant to its terms. The obligations
of HCS under the FNCC Credit Agreement are secured by HCS’s inventory and accounts receivable.

The FNCC Credit Agreement contains customary representations, warranties and affirmative and negative covenants, including
but not limited to financial covenants. The FNCC Credit Agreement also contains customary events of default, including but not
limited to payment defaults, cross defaults with certain other indebtedness, breaches of covenants and bankruptcy events. In
the case of an event of default, FNCC may, among other remedies, accelerate payment of all obligations under the FNCC
Credit Agreement. In connection with the FNCC Credit Agreement, the Company executed a guaranty in favor of FNCC
guaranteeing all of HCS’s obligations under the FNCC Credit Agreement.

At the time of the Company's filing of its Quarterly Report on Form 10-Q for the quarter ended September 30, 2017, management concluded that substantial doubt existed about the Company's ability to continue as a going concern within one year after the date that the consolidated financial statements were issued. Management’s assessment was based on the expected negative impact on cash flow related to the loss of a significant customer of HCS. In addition, management was unsure of its ability to generate cash flow through other means, such as selling the Company's marketable securities at acceptable prices and uncertainty as to whether the Company could efficiently transfer the securities and receive cash proceeds in order to meet obligations as they come due.

Subsequent to that filing and subsequent to year end, the Company engaged a major investment firm to evaluate the marketplace for its mortgage securities. Management learned during that process that a market exists for the Company’s mortgage securities and that those securities may be sold at prices acceptable to the Company. The Company executed trades to sell a portion of its overcollateralization mortgage securities. These sales are expected to generate $2.9 million in cash proceeds for the Company. Management believes that other mortgage securities may be sold on similar terms in the event additional cash proceeds are needed. In addition, through the date of this filing, HCS has demonstrated that it can provide positive cash flow sufficient to support HCS operations. Management continues to work toward expanding HCS’s customer base by increasing revenue from existing customers and targeting new customers that have not previously been served by HCS. In addition, management is exploring cost cutting initiatives that will reduce overall corporate overhead and operating costs.

While our historical operating results and poor cashflow suggest substantial doubt exists related to the Company’s ability to continue as a going concern, management has concluded that the factors discussed above have alleviated the substantial doubt about the Company's ability to continue as a going concern within one year after the date that these consolidated financial statements are issued. The accompanying consolidated financial statements have been prepared on a basis that assumes the Company will continue as a going concern and contemplates the continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business.


13



Overview of Cash Flow for the Year Ended December 31, 2017
The following table provides a summary of our operating, investing and financing cash flows as taken from our consolidated statements of cash flows for 2017 and 2016 (in thousands).
 
For the Year Ended
December 31,
 
2017
 
2016
Consolidated Statements of Cash Flows:
 
 
 
Cash flows (used in) provided by operating activities of continuing operations
$
(9,621
)
 
$
2,116

Cash flows provided by investing activities of continuing operations
3,510

 
1,591

Cash flows used in financing activities of continuing operations
3,151

 
(205
)

Operating Activities
The decrease in net cash flows from operating activities to approximately $9.6 million used in operating activities during 2017 from approximately $2.1 million provided by operating activities during 2016 was driven primarily by the net loss and the payment of interest on the 2017 Notes and the Company's unpaid accounts payable and accrued expenses, primarily accrued professional fees.

Investing Activities
The increase in the net cash flows provided by investing activities is due primarily to proceeds from the sale of marketable securities, less the investment by the Company in HCS.
 
Financing Activities
During 2017, HCS entered into the FNCC Credit Agreement with FNCC providing HCS with a line of credit of up to $5,000,000. Availability under the FNCC Credit Agreement is based on a formula tied to HCS’s eligible accounts receivable. The Company’s financing activities include the borrowings and payments under that credit facility during 2017.

Critical Accounting Estimates
We prepare our consolidated financial statements in conformity with GAAP and, therefore, are required to make estimates regarding the values of our assets and liabilities and in recording income and expenses. These estimates are based, in part, on our judgment and assumptions regarding various economic conditions that we believe are reasonable based on facts and circumstances existing at the time of reporting. These estimates affect reported amounts of assets, liabilities and accumulated other comprehensive income at the date of the consolidated financial statements and the reported amounts of income, expenses and other comprehensive income during the periods presented. The following summarizes the components of our consolidated financial statements where understanding accounting policies is critical to understanding and evaluating our reported financial results, especially given the significant estimates used in applying the policies. The discussion is intended to demonstrate the significance of estimates to our consolidated financial statements and the related accounting policies. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of our Board and the Audit Committee has reviewed our disclosure.

Marketable Securities
Our marketable securities include corporate equity and debt instruments and other traditional liquid investments, such as agency mortgage-backed securities. In addition, they include beneficial interests in the mortgage securitizations we executed prior to 2008. These beneficial interests include interest-only mortgage securities, residual interests and over-collateralization bonds, collectively "retained mortgage securities."

The accounting estimates used in valuing the retained mortgage securities and determining their income recognition rate are “critical accounting estimates” because they can materially affect net income (loss) and shareholders’ equity. In order to determine value, we must forecast interest rates, mortgage principal payments, prepayments and loan default assumptions and when, or if, the servicer for the underlying mortgage loans will exercise optional redemption rights (the "call date"). Making these assumptions requires a large degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our residual securities. Management’s best estimate of key assumptions, including credit losses, prepayment speeds, expected call dates, market discount rates and forward yield curves commensurate with the risks involved, are used in estimating future cash flows.

We use historical collateral performance data, market economic data and published forward yield curves when modeling future expected cash flows and establishing the rate of income recognized on our retained mortgage securities. At each reporting date, future expected cash flows to be received is forecasted based on the assumptions made. The fair value of the retained mortgage securities is estimated by discounting these cash flows. We have relied heavily on historical performance of non-prime mortgage loans, in general, to determine assumptions. However, market trends for housing prices, labor statistics and other economic

14



factors have consistently improved for several years. Sufficient time has passed to suggest that these trends are sustainable. Therefore, we are now relying more heavily on the specific performance of these loans in forecasting cash flow from our retained mortgage securities. To date, these specific loans have performed significantly better than non-prime loans in general. Better performance by the underlying mortgage securities generally results in more cash flow and higher values for our retained mortgage securities.

We believe the value of our residual securities is appropriate, but can provide no assurance that future changes in interest rates, prepayment and loss experience or changes in the market discount rate will not require material adjustments to the retained mortgage securities. See Note 10 to the consolidated financial statements for additional information on the estimates used in the valuation of our retained mortgage securities.

Impairment of Goodwill and Indefinite-Lived Intangible Assets

The values of goodwill and trademarks are assessed annually to determine whether their carrying value exceeds their fair value. In addition, they are tested on an interim basis if an event occurs or circumstances change between annual tests that would more likely than not reduce their fair value below carrying value. If we determine the fair value of goodwill or trademarks is less than their carrying value, an impairment loss is recognized. Impairment losses, if any, are reflected in operating income or loss in the period incurred. The Company performs its annual tests of goodwill and trademarks during the second quarter of each fiscal year.

Impairment of Long-Lived Assets with Finite Lives

The value of purchased intangible assets is assessed for impairment whenever an event or change in circumstances indicates that the carrying value of the asset may not be fully recoverable. Recoverability is determined based on an estimate of undiscounted future cash flows resulting from the use of an asset and its eventual disposition. An impairment loss is measured by comparing the fair value of the asset to its carrying value. If we determine the fair value of an asset is less than the carrying value, an impairment loss is incurred. Impairment losses, if any, are reflected in operating income or loss in our consolidated statements of operations during the period incurred.

Income Taxes
In determining the amount of deferred tax assets to recognize in the consolidated financial statements, the Company evaluates the likelihood of realizing such benefits in future periods. The income taxes guidance requires the recognition of a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized. Income tax guidance indicates the more likely than not threshold is a level of likelihood that is more than 50%.
 
Under the income tax guidance, companies are required to identify and consider all available evidence, both positive and negative, in determining whether it is more likely than not that all or some portion of its deferred tax assets will not be realized. Positive evidence includes, but is not limited to the following: cumulative earnings in recent years, earnings expected in future years, excess appreciated asset value over the tax basis and positive industry trends. Negative evidence includes, but is not limited to the following: cumulative losses in recent years, losses expected in future years, a history of operating losses or tax credit carryforwards expiring, and adverse industry trends.
 
The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is required to counter to support a conclusion that a valuation allowance is not needed for all or some of the deferred tax assets. Cumulative losses in recent years are significant negative evidence that is difficult to overcome when determining the need for a valuation allowance. Similarly, cumulative earnings in recent years represent significant positive objective evidence. If the weight of the positive evidence is sufficient to support a conclusion that it is more likely than not that a deferred tax asset will be realized, a valuation allowance should not be recorded.
 
The Company examines and weighs all available evidence (both positive and negative and both historical and forecasted) in the process of determining whether it is more likely than not that a deferred tax asset will be realized. The Company considers the relevance of historical and forecasted evidence when there has been a significant change in circumstances. Additionally, the Company evaluates the realization of its recorded deferred tax assets on an interim and annual basis. The Company does not record a full valuation allowance if the weight of the positive evidence exceeds the negative evidence and is sufficient to support a conclusion that it is more likely than not that its deferred tax asset will be realized.
 
If a valuation allowance is necessary, the Company considers all sources of taxable income in determining the amount of valuation allowance to be recorded. Sources of taxable income identified in the income tax guidance include the following: 1) taxable income in prior carryback year, 2) future reversals of existing taxable temporary differences, 3) future taxable income exclusive of reversing temporary differences and carryforwards, and 4) tax planning strategies.
 
The Company currently evaluates estimates of uncertainty in income taxes based upon a framework established in the income tax accounting guidance. The guidance prescribes a recognition threshold and measurement standard for the recognition and measurement of tax positions taken or expected to be taken in a tax return. In accordance with the guidance, the Company

15



evaluates whether a tax position will more likely than not be sustained upon examination by the appropriate taxing authority. The Company measures the amount to recognize in its consolidated financial statements as the largest amount that is greater than 50% likely of being realized upon ultimate settlement. The recognition and measurement of tax benefits is often judgmental, and determinations regarding the tax benefit can change as additional developments occur relative to the issue.

Impact of Recently Issued Accounting Pronouncements
Information regarding the impact of recently issued accounting pronouncements is included in Note 3 to the consolidated financial statements.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Not applicable.


16



Item 8. Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
NOVATION COMPANIES, INC. AND SUBSIDIARIES
 

 
 
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations and Comprehensive Income (Loss)
Consolidated Statements of Shareholders' Deficit
Consolidated Statements of Cash Flow
Notes to Consolidated Financial Statements
 
 


17




REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and
Stockholders of Novation Companies, Inc.

Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheets of Novation Companies, Inc. (the Company) as of December 31, 2017 and 2016, and the related statements of operations and comprehensive income (loss), shareholders deficit, and cash flows for each of the years in the two-year period ended December 31, 2017, and the related notes (collectively referred to as the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2017, in conformity with accounting principles generally accepted in the United States of America.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits, we are required to obtain an understanding of internal control over financial reporting, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.
Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.



/s/ BOULAY PLLP
We have served as the Company's auditor since 2016.
Minneapolis, Minnesota
April 10, 2018

18



NOVATION COMPANIES, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
 
December 31,
 
2017
 
2016
Assets
 
 
 
Current Assets
 
 
 
Cash and cash equivalents
$
2,740

 
$
4,805

Accounts and unbilled receivables
7,922

 

Marketable securities
11,795

 
9,943

Other current assets
578

 
1,091

Total current assets
23,035

 
15,839

Non-Current Assets
 
 
 
Goodwill
8,205

 

Intangible assets, net
8,172

 

Marketable securities

 
26,545

Other
425

 
246

Total non-current assets
16,802

 
26,791

Total assets
$
39,837

 
$
42,630

 
 
 
 
Liabilities and Shareholders' Deficit
 
 
 
Liabilities:
 
 
 
Current Liabilities
 
 
 
Borrowings under revolving line of credit
$
3,333

 
$

Accrued compensation and benefits payable
4,213

 
75

Accrued professional fees payable
1,037

 
691

Accrued interest payable
1,050

 
3,689

Other
1,650

 
1,063

Total current liabilities
11,283

 
5,518

Non-Current Liabilities
 
 
 
Long-term debt
86,050

 
85,938

Other
386

 
373

Total non-current liabilities
86,436

 
86,311

Total liabilities
97,719

 
91,829

 
 
 
 
Commitments and contingencies


 


 
 
 
 
Shareholders' Deficit:
 
 
 
Capital stock, $0.01 par value per share, 120,000,000 shares authorized:
 
 
 
Common stock, 97,138,750 and 92,844,907shares issued and outstanding as of December 31, 2017 and 2016, respectively
971

 
928

Additional paid-in capital
744,937

 
744,873

Accumulated deficit
(815,184
)
 
(804,319
)
Accumulated other comprehensive income
11,394

 
9,319

Total shareholders' deficit
(57,882
)
 
(49,199
)
Total liabilities and shareholders' deficit
$
39,837

 
$
42,630

 
 
 
 
See notes to consolidated financial statements.

19



NOVATION COMPANIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(in thousands, except share and per share amounts)
 
For the Year Ended
December 31,
 
2017
 
2016
Service fee income
$
27,965

 
$

Cost and expenses:
 
 
 
Cost of services
24,473

 

General and administrative
6,713

 
4,367

Goodwill impairment charge
4,500

 

Operating loss
(7,721
)
 
(4,367
)
 
 
 
 
Interest income – mortgage securities
3,143

 
5,060

Other income (expense)
348

 
5,472

Reorganization items, net
(3,581
)
 
667

Interest expense
(3,935
)
 
(3,606
)
 
 
 
 
Income (loss) from continuing operations before income taxes
(11,746
)
 
3,226

Income tax expense (benefit)
14

 
(21
)
Net income (loss) from continuing operations
(11,760
)
 
3,247

Income from discontinued operations, net of income taxes
895

 
1,966

Net income (loss)
(10,865
)
 
5,213

 
 
 
 
Other comprehensive income:
 
 
 
Less reclassification gain included in net income

(137
)
 
(3,672
)
Change in unrealized gain (loss) on marketable securities
2,212

 
11,555

Other comprehensive income (loss)
2,075

 
7,883

Net comprehensive income (loss)
$
(8,790
)
 
$
13,096

 
 
 
 
Earnings (loss) per common share:
 
 
 
Basic
$
(0.12
)
 
$
0.06

Diluted
$
(0.12
)
 
$
0.06

Weighted average basic common shares outstanding
92,800,392

 
91,905,941

Weighted average diluted common shares outstanding
92,800,392

 
91,905,941




20



NOVATION COMPANIES, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ DEFICIT
(in thousands)
 
Common
Stock
 
Additional
Paid-in
Capital
 
Accumulated
Deficit
 
Accumulated
Other
Comprehensive
Income
 
Total
Shareholders’
Deficit
Balance, December 31, 2016
$
928

 
$
744,873

 
$
(804,319
)
 
$
9,319

 
$
(49,199
)
Issuance of nonvested shares
43

 
(43
)
 

 

 

Compensation recognized under stock compensation plans

 
107

 

 

 
107

Net loss

 

 
(10,865
)
 

 
(10,865
)
Other comprehensive income

 

 

 
2,075

 
2,075

Balance, December 31, 2017
$
971

 
$
744,937

 
$
(815,184
)
 
$
11,394

 
$
(57,882
)

Balance, December 31, 2015
$
928

 
$
744,575

 
$
(809,532
)
 
$
1,436

 
$
(62,593
)
Compensation recognized under stock compensation plans

 
298

 

 

 
298

Net income

 

 
5,213

 

 
5,213

Other comprehensive income

 

 

 
7,883

 
7,883

Balance, December 31, 2016
$
928

 
$
744,873

 
$
(804,319
)
 
$
9,319

 
$
(49,199
)
 
 
 
 
 
 
 
 
 
 
See notes to consolidated financial statements.
 
 
 
 
 
 
 
 
 


21



NOVATION COMPANIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
For the Year Ended
December 31,
 
2017
 
2016
Cash flows from operating activities:
 
 
 
Net income (loss)
$
(10,865
)
 
$
5,213

Income from discontinued operations, net of income taxes
895

 
1,966

Net income (loss) from continuing operations
(11,760
)
 
3,247

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
 
 
 
Goodwill impairment charge
4,500

 

Gains on sales of marketable securities, net
(137
)
 
(3,672
)
Accretion of marketable securities, net
58

 
16

Adjustments to and amortization of deferred debt issuance costs and senior debt discount

 
(2,447
)
Compensation recognized under stock compensation plans
107

 
274

Amortization of intangible assets
496

 

Changes in operating assets and liabilities, net of acquisition:
 
 
 
Accounts receivable
(457
)
 

Accrued professional fees payable
346

 
315

Accrued compensation and benefits payable
(613
)
 
(200
)
Accrued interest payable
(2,639
)
 
3,687

Due from discontinued operations

 
(26
)
Other current assets and liabilities, net
63

 
329

Other noncurrent assets and liabilities, net
415

 
593

Net cash provided by (used in) operating activities of continuing operations
(9,621
)
 
2,116

Net cash provided by (used in) operating activities of discontinued operations
895

 
(1,921
)
Net cash provided by (used in) operating activities
(8,726
)
 
195

 
 
 
 
Cash flows from investing activities:
 
 
 
Proceeds from sales and maturities of marketable securities
26,847

 
33,468

Purchase of business, net of cash received
(23,337
)
 

Proceeds from sale of subsidiary

 
7,643

Purchases of available for sale securities

 
(39,520
)
Net cash provided by investing activities of continuing operations
3,510

 
1,591

Net cash used in investing activities of discontinued operations

 
(159
)
Net cash provided by investing activities
3,510

 
1,432

 
 
 
 
Cash flows from financing activities:
 
 
 
Borrowings under revolving line of credit
10,043

 

Repayments of borrowings under revolving line of credit
(6,710
)
 

Paydowns of long-term debt
(182
)
 

Cash receipts from distributions of earnings from discontinued operations

 
(205
)
Net cash used in financing activities of continuing operations
3,151

 
(205
)
Net cash provided by financing activities of discontinued operations

 
205

Net cash provided by financing activities
3,151

 

Net increase (decrease) in cash and cash equivalents
(2,065
)
 
1,627

Cash and cash equivalents, beginning of period
4,805

 
3,178

Cash and cash equivalents, end of period
$
2,740

 
$
4,805

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

22



 
For the Year Ended
December 31,
 
2017
 
2016
Supplemental disclosure of cash flow information:
 
 
 
Cash paid for reorganization items
$
4,501

 
$
902

Cash paid for interest
$
6,557

 
$

Cash income taxes paid, net
$

 
(17
)
 
 
 
 
Supplemental disclosure of financing and investing activities:
 
 
 
Assets acquired and liabilities assumed in connection with purchase of business:
 
 
 
Cash and cash equivalents
$
246

 
$

Accounts receivable
7,465

 

Other current assets
59

 

Other assets
581

 

Intangible assets
8,669

 

Goodwill
12,705

 

Accrued compensation and benefits
(4,751
)
 

Long-term debt, including current portion of $426
(683
)
 

Other current liabilities
(708
)
 

Purchase price
$
23,583

 
$

See notes to consolidated financial statements.

23



NOVATION COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 . Basis of Presentation, Business Plan and Liquidity

Description of Operations – Novation Companies, Inc. and its subsidiaries (the “Company,” “Novation,” “we,” or “us”), through Healthcare Staffing, Inc. ("HCS"), our wholly-owned subsidiary acquired on July 27, 2017, provides outsourced health care staffing and related services in the State of Georgia. We also own a portfolio of mortgage securities which generate earnings to support on-going financial obligations. Our common stock, par value $0.01 per share, is traded on the OTC Pink marketplace of the OTC Markets Group, Inc. under the symbol “NOVC”.

Liquidity and Going Concern – During 2017, the Company incurred a net loss of $10.9 million and generated negative operating cashflow of $ 8.7 million . As of December 31, 2017 the Company has an overall shareholders deficit of $ 57.9 million . As of December 31, 2017 the Company had an aggregate of $2.7 million in cash and cash equivalents and total liabilities of $97.7 million . Of the $2.7 million in cash, $1.1 million is held by the Company's subsidiary NovaStar Mortgage LLC ("NMLLC"), which has filed a Chapter 11 plan of reorganization that remains subject to court approval. This cash is available to pay general creditors and expenses of NMLLC. The Company also has a significant on-going obligation to pay interest under its senior note agreement. In addition, beginning in 2018 a significant customer significantly reduced the level of staff outsourced to HCS.

At the time of the Company's filing of its Quarterly Report on Form 10-Q for the quarter ended September 30, 2017, management concluded that substantial doubt existed about the Company's ability to continue as a going concern within one year after the date that the consolidated financial statements were issued. Management’s assessment was based on the expected negative impact on cash flow related to the loss of a significant customer of HCS. In addition, management was unsure of its ability to generate cash flow through other means, such as selling the Company's marketable securities at acceptable prices and uncertainty as to whether the Company could efficiently transfer the securities and receive cash proceeds in order to meet obligations as they come due.

Subsequent to that filing and subsequent to year end, the Company engaged a major investment firm to evaluate the marketplace for its mortgage securities. Management learned during that process that a market exists for the Company’s mortgage securities and that those securities may be sold at prices acceptable to the Company. The Company executed trades to sell a portion of its overcollateralization mortgage securities. These sales are expected to generate $2.9 million in cash proceeds for the Company. Management believes that other mortgage securities may be sold on similar terms in the event additional cash proceeds are needed. In addition, through the date of this filing, HCS has demonstrated that it can provide positive cash flow sufficient to support HCS operations. Management continues to work toward expanding HCS’s customer base by increasing revenue from existing customers and targeting new customers that have not previously been served by HCS. In addition, management is exploring cost cutting initiatives that will reduce overall corporate overhead and operating costs.

While our historical operating results and poor cashflow suggest substantial doubt exists related to the Company’s ability to continue as a going concern, management has concluded that the factors discussed above have alleviated the substantial doubt about the Company's ability to continue as a going concern within one year after the date that these consolidated financial statements are issued. The accompanying consolidated financial statements have been prepared on a basis that assumes the Company will continue as a going concern and contemplates the continuity of operations, realization of assets and the satisfaction of liabilities and commitments in the normal course of business.

We cannot provide assurance that revenue generated from our businesses will be sufficient to sustain our operations in the long term. Additionally, we cannot be certain that we will be successful at raising capital, whether from divesting of mortgage securities or other assets, or from equity or debt financing, on commercially reasonable terms, if at all. Such failures would have a material adverse effect on our business, including the possible cessation of operations.

Financial Statement Presentation. The Company’s consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of income and expense during the period. The Company uses estimates and judgments in establishing the fair value of its mortgage securities, assessing the recoverability of goodwill intangible assets and accounting for income taxes, including the determination of the timing of the establishment or release of the valuation allowance related to the deferred tax asset balances and reserves for uncertain tax positions. While the consolidated financial statements and footnotes reflect the best estimates and judgments of management at the time, actual results could differ significantly from those estimates.

Note 2 . Reorganization

On July 20, 2016, (the "Bankruptcy Petition Date"), Novation and three of its subsidiaries, NMLLC, NovaStar Mortgage Funding Corporation and 2114 Central LLC (collectively, the “Debtors”), filed voluntary petitions (the "Bankruptcy Petitions") for reorganization under Chapter 11 Title 11 of the United States Code (the "Bankruptcy Code") in the United States Bankruptcy

24



Court for the District of Maryland (the "Bankruptcy Court"). The Company and one of its subsidiaries subsequently filed with the Bankruptcy Court, and amended, a plan of reorganization for the resolution of the outstanding claims against and interests pursuant to Section 1121(a) of the Bankruptcy Code (as amended and supplemented, the “Plan”) and a related disclosure statement. The Bankruptcy Court entered an order on June 12, 2017 confirming the Plan (the “Confirmation Order”) solely with respect to the Company, which provided that the effective date of the Plan would occur when all conditions precedent to effectiveness, as set forth in the Plan, had been satisfied or waived.

Two of the conditions to the effectiveness of the Plan were (i) the closing of the Company’s acquisition (the “HCS Acquisition”) of all of the capital stock of HCS as discussed in Note 4 and (ii) the restructuring (the “Note Refinancing”) of the Company’s outstanding Series 1 Notes, Series 2 Notes and Series 3 Notes (collectively, the “2011 Notes”), held by Taberna Preferred Funding I, Ltd. (“Taberna I”), Taberna Preferred Funding II, Ltd. (“Taberna II”) and Kodiak CDO I, Ltd. (“Kodiak” and, together with Taberna I and Taberna II, the “Noteholders”), issued pursuant to three Indentures, each dated as of March 22, 2011 (the “Indentures”), between the Company and The Bank of New York Mellon Trust Company, National Association. The HCS Acquisition and the Note Refinancing were completed on July 27, 2017, and are discussed in Note 4 and Note 8 , respectively.

On July 27, 2017, upon the completion of the HCS Acquisition and the Note Refinancing, and the satisfaction or waiver of all other conditions precedent to effectiveness, the effective date of the Plan occurred and the Company filed a Notice of Occurrence of Effective Date of the Plan with the Bankruptcy Court. Under the Plan, holders of existing equity interests in the Company (i.e., the common stock) retained their interests.

On September 25, 2017, the bankruptcy case of 2114 Central, LLC was dismissed by order of the Bankruptcy Court. Thereafter, on December 22, 2017, NMLLC filed with the Bankruptcy Court a Chapter 11 plan of reorganization, and on December 26, 2017 filed a related disclosure statement. The Bankruptcy Court entered an order on February 16, 2018 approving the disclosure statement, as revised. The Bankruptcy Court will conduct a hearing on April 11, 2018 to consider confirmation of NMLLC’s plan of reorganization.

We incurred significant costs associated with our reorganization and the Chapter 11 proceedings. These costs, which are being expensed as incurred, include (in thousands):
 
Year Ended December 31,
 
2017
 
2016
Adjustments to deferred debt issuance costs and senior debt premium
$

 
$
2,399

Professional fees
(3,460
)
 
(1,252
)
Adjustments to other liabilities for claims made or rejected contracts
(87
)
 
(449
)
Other
(34
)
 
(31
)
Reorganization items, net
$
(3,581
)
 
$
667


Note 3. Summary of Significant Accounting and Reporting Policies

Recently Adopted Accounting Principles. In January 2017, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2017-04,  Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment to eliminate a step in the quantitative goodwill impairment test. The new single quantitative step test requires companies to compare the fair value of a reporting unit with its carrying amount and record an impairment charge for the amount that the carrying amount exceeds the fair value, up to the total amount of goodwill allocated to that reporting unit. The Company will continue to have the option of first performing a qualitative assessment to determine whether it is necessary to complete the quantitative goodwill impairment test. The Company early adopted this guidance in the fourth quarter of 2017 by applying the single quantitative step test to our interim goodwill impairment analysis. See Note 7.

Cash and Cash Equivalents. Cash equivalents consist of liquid investments with an original maturity of three months or less. Cash equivalents are stated at cost, which approximates fair value. The Company maintains cash balances at four major financial institutions in the United States. Accounts are secured by the Federal Deposit Insurance Corporation up to $250,000. The uninsured balances of the Company’s unrestricted cash and cash equivalents accounts aggregated $2.0 million as of December 31, 2017 .

Accounts and Unbilled Receivables. Accounts receivable are uncollateralized customer obligations due under normal trade terms. Customer account balances that are not paid within contract terms are considered delinquent. Accounts receivable are stated at the amount management expects to collect from outstanding balances. The Company maintains an allowance for potential losses primarily based upon management's analysis of delinquent accounts, routine assessment of its customers' financial condition, and any other known factors impacting collectability, including disputed amounts. When management has exhausted all collection efforts, amounts deemed uncollectible are written off. Recoveries of previously written off accounts receivable are recognized in the period in which they are received. The ultimate amount of accounts receivable that becomes uncollectible could differ from management's estimate.


25



Marketable Securities – Available-for-Sale. Marketable securities are stated at fair value in accordance with the relevant accounting guidance. The Company determines the fair value of its marketable securities based on pricing from our third party service provider and market prices from industry-standard independent data providers. Such market prices may be quoted prices in active markets for identical assets (Level 1 inputs) or pricing determined using inputs other than quoted prices that are observable either directly or indirectly (Level 2 inputs), such as yield curve, volatility factors, credit spreads, default rates, loss severity, current market and contractual prices for the underlying instruments or debt, broker and dealer quotes, as well as other relevant economic measures. To the extent observable inputs are not available, as is the case with the Company's mortgage securities – available-for-sale, the Company estimates fair value using significant unobservable inputs (Level 3 inputs). The methods and processes used to estimate the fair value of the Company's mortgage securities are discussed further below.

Mortgage securities – available-for-sale represent beneficial interests the Company retains in securitization transactions which consist of residual interests (the “residual securities”) in certain components of the cash flows of the underlying mortgage loans to the securitization trusts. As payments are received on the residual securities, the payments are applied to the cost basis of the related mortgage securities. Each period, the accretable yield for each mortgage security is evaluated and, to the extent there has been a change in the estimated cash flows, it is adjusted and applied prospectively. The accretable yield is recorded as interest income with a corresponding increase to the carrying basis of the mortgage security. The Company estimates the fair value of its residual securities retained based on the present value of future expected cash flows to be received, except for those securities for which a portion was sold subsequent to year end as discussed in Note 10. Management’s best estimate of key assumptions, including credit losses, prepayment speeds, market discount rates and forward yield curves commensurate with the risks involved, are used in estimating future cash flows.

All of the Company's available-for-sale securities are reported at their estimated fair value with unrealized gains and losses reported in accumulated other comprehensive income. To the extent the cost basis of these securities exceeds the estimated fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. The Company uses the specific identification method in computing realized gains or losses.

Goodwill and Indefinite-Lived Intangible Assets.  Goodwill and trademarks are assessed annually to determine whether their carrying value exceeds their fair value. In addition, they are tested on an interim basis if an event occurs or circumstances change between annual tests that would more likely than not reduce their fair value below carrying value. If we determine the fair value of goodwill or trademarks is less than their carrying value, an impairment loss is recognized. Impairment losses, if any, are reflected in operating income or loss in the period incurred. The Company performs its annual tests of goodwill and trademarks during the second quarter of each fiscal year.

Impairment of Long-Lived Intangible Assets with Finite Lives.  Long-lived intangible assets held and used by us which have finite lives are assessed for impairment whenever an event or change in circumstances indicates that the carrying value of the asset may not be fully recoverable. Recoverability is determined based on an estimate of undiscounted future cash flows resulting from the use of an asset and its eventual disposition. An impairment loss is measured by comparing the fair value of the asset to its carrying value. If we determine the fair value of an asset is less than the carrying value, an impairment loss is incurred. Impairment losses, if any, are reflected in operating income or loss in the period incurred.

Revenue and Cost Recognition - The Company recognizes revenue when there is persuasive evidence of an arrangement, the service has been provided to the customer, fees for services are fixed or determinable and collectability is reasonably assured. HCS's revenue is generated from time and material contracts where there is a signed agreement in place that specifies the fixed hourly rate and other reimbursable costs to be billed based on direct labor hours incurred. Revenue is recognized on these contracts based on direct labor hours and reimbursable costs incurred.

During 2017, 43% of Service Fee Income was generated from two customers and 98% was generated from 16 Community Service Board ("CSB") customers. As of December 31, 2017, 48% of accounts and unbilled receivables were due from three customers and 97% was due from the 16 CSB customers.

Income Taxes. The Company had a gross deferred tax asset of $164.7 million and $295.9 million as of December 31, 2017 and 2016 , respectively. In determining the amount of deferred tax assets to recognize in the consolidated financial statements, the Company evaluates the likelihood of realizing such benefits in future periods. The income tax guidance requires the recognition of a valuation allowance if it is more likely than not that all or some portion of the deferred tax asset will not be realized. Income tax guidance indicates the more likely than not threshold is a level of likelihood that is more than 50%.

Under the income tax guidance, companies are required to identify and consider all available evidence, both positive and negative, in determining whether it is more likely than not that all or some portion of its deferred tax assets will not be realized. Positive evidence includes, but is not limited to the following: cumulative earnings in recent years, earnings expected in future years, excess appreciated asset value over the tax basis and positive industry trends. Negative evidence includes, but is not limited to the following: cumulative losses in recent years, losses expected in future years, a history of operating losses or tax credit carryforwards expiring, and adverse industry trends.


26



The weight given to the potential effect of negative and positive evidence should be commensurate with the extent to which it can be objectively verified. The more negative evidence that exists, the more positive evidence is required to counter to support a conclusion that a valuation allowance is not needed for all or some of the deferred tax assets. Cumulative losses in recent years are significant negative evidence that is difficult to overcome when determining the need for a valuation allowance. Similarly, cumulative earnings in recent years represent significant positive objective evidence. If the weight of the positive evidence is sufficient to support a conclusion that it is more likely than not that a deferred tax asset will be realized, a valuation allowance should not be recorded.

The Company examines and weighs all available evidence (both positive and negative and both historical and forecasted) in the process of determining whether it is more likely than not that a deferred tax asset will be realized. The Company considers the relevance of historical and forecasted evidence when there has been a significant change in circumstances. Additionally, the Company evaluates the realization of its recorded deferred tax assets on an interim and annual basis. The Company does not record a full valuation allowance if the weight of the positive evidence exceeds the negative evidence and is sufficient to support a conclusion that it is more likely than not that its deferred tax asset will be realized.

If a valuation allowance is necessary, the Company considers all sources of taxable income in determining the amount of valuation allowance to be recorded. Sources of taxable income identified in the income tax guidance include the following: 1) taxable income in prior carryback year, 2) future reversals of existing taxable temporary differences, 3) future taxable income exclusive of reversing temporary differences and carryforwards, and 4) tax planning strategies.

The Company currently evaluates estimates of uncertainty in income taxes based upon a framework established in the income tax accounting guidance. The guidance prescribes a recognition threshold and measurement standard for the recognition and measurement of tax positions taken or expected to be taken in a tax return. In accordance with the guidance, the Company evaluates whether a tax position will more likely than not be sustained upon examination by the appropriate taxing authority. The Company measures the amount to recognize in its consolidated financial statements as the largest amount that is greater than 50% likely of being realized upon ultimate settlement. The recognition and measurement of tax benefits is often judgmental, and determinations regarding the tax benefit can change as additional developments occur relative to the issue.

Earnings (Loss) Per Share (“EPS”). Basic EPS excludes dilution and is computed by dividing net income (loss) available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Diluted EPS is calculated assuming all options, nonvested shares and performance-based awards of the Company's common stock have been exercised, unless the exercise would be antidilutive. See Note 11 to the consolidated financial statements for additional details on earnings per share calculation.

New Accounting Pronouncements

In May 2014, the FASB issued ASU No. 2014-09, which amended Revenue from Contracts with Customers (Topic 606). The core principle of the new guidance is that an entity should recognize revenue to reflect the transfer of goods and services to customers in an amount equal to the consideration the entity receives or expects to receive. With respect to public entities, this guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2017. Early application is not permitted. The Company has determined the adoption of this guidance will have no material impact on the way revenue is recognized. Additional disclosure will be required in the footnotes to the consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842). This ASU requires lessees to recognize the assets and liabilities that arise from leases on the balance sheet. A lessee should recognize in its balance sheet a liability to make lease payments and an asset representing its right to use the underlying asset for the lease term. This guidance is effective for annual and interim reporting periods beginning after December 15, 2018. The amendments should be applied at the beginning of the earliest period presented using a modified retrospective approach with earlier application permitted as of the beginning of an interim or annual reporting period. The Company is evaluating the impact this guidance will have on its consolidated financial statements.

Note 4 . Acquisition and Divestiture

Acquisition of Healthcare Staffing, Inc. On February 1, 2017, the Company entered into a Stock Purchase Agreement (the “HCS Purchase Agreement”) with Novation Holding, Inc., a wholly-owned subsidiary of the Company (“NHI”), HCS and Butler America, LLC, the owner of HCS (“Butler” and, together with HCS, the “Seller Parties”). Pursuant to the HCS Purchase Agreement, NHI agreed to purchase from Butler all of the outstanding capital stock of HCS for $24.0 million in cash, subject to terms and conditions as provided therein, including but not limited to the Company’s receipt of bankruptcy court approval for the HCS Acquisition in its Chapter 11 case. The purchase price was subject to a potential working capital adjustment, based on HCS having $5.0 million of working capital at closing.

On July 27, 2017, in connection with the anticipated closing of the HCS Acquisition, the Company, NHI, HCS and Butler entered into a Closing Agreement, dated as of the same date (the “Closing Agreement”), relating to certain closing matters and the terms

27



of the HCS Purchase Agreement. The Closing Agreement provided for the following: (i) eliminate the $240,000 indemnification escrow under the HCS Purchase Agreement; (ii) provide for NHI’s reimbursement to Butler of $100,000 in costs and expenses incurred by Butler in consideration for the delay in closing the HCS Acquisition; (iii) clarify the treatment of certain of HCS’s outstanding tax obligations; (iv) provide that an adjustment to the purchase price under the HCS Purchase Agreement will be made in connection with the calculation of final closing date net working capital of HCS only if there is a difference between such amount and the pre-closing estimate of greater than three percent; and (v) make certain other changes to the HCS Purchase Agreement. We have made claims against Butler for a working capital adjustment, indemnification and other reimbursements and payments under the terms of the HCS Purchase Agreement and are in discussions with Butler regarding these claims. As of the date of this filing, the claims are unresolved and the Company has not recorded any amounts for these claims in the consolidated financial statements.

On July 27, 2017, the Company and NHI completed the HCS Acquisition pursuant to the terms of the HCS Purchase Agreement and the Closing Agreement, as a result of which HCS became a wholly-owned subsidiary of NHI.

The net purchase price was allocated as follows (in thousands):
Cash
$
246

Accounts receivable
7,465

Other assets
59

Property and equipment
581

Intangible assets:
 
Customer relationships
6,895

Trademark
1,147

Non-compete
627

Goodwill
12,705

Accrued compensation and benefits
(4,751
)
Long-term debt, including current portion of $426
(683
)
Other current liabilities
(708
)
Net assets acquired
$
23,583


The purchase price was allocated to the tangible and intangible assets acquired and the liabilities assumed at their estimated fair values as of the acquisition date. The fair value measurements of the assets acquired and liabilities assumed were based on valuations involving significant unobservable inputs, or Level 3 in the valuation hierarchy. The allocation of the purchase price above to the assets and liabilities are based on our preliminary assessment and is subject to further review pending the completion of an appraisal of certain assets and liabilities acquired.

The gross contractual amount of accounts receivable is $7.5 million , which approximates fair value. Goodwill and trademarks are considered indefinite-lived assets and are not subject to future amortization, but will be tested for impairment at least annually. Goodwill is comprised primarily of processes for services and knowhow, assembled workforces and other intangible assets that do not qualify for separate recognition. The amortization period for the intangibles for customer relationships and the non-compete agreement are seven and three years, respectively. The goodwill will be deductible for tax purposes.

HCS’s results are included in our consolidated statement of operations beginning July 27, 2017. The following unaudited pro forma financial information presents the combined results of HCS and Novation as if the HCS Acquisition had occurred on January 1, 2016 (in thousands). The unaudited pro forma financial information is not necessarily indicative of what our consolidated results of operations actually would have been or what results may be expected in the future.
 
For the Year Ended December 31,
 
2017
 
2016
Service fee income
$
63,246

 
$
55,161

Income (loss) from continuing operations
$
(9,331
)
 
$
3,903

Net income (loss)
$
(8,450
)
 
$
5,869

 
 
 
 
Basic and diluted earnings per share:
 
 
 
Net income (loss) from continuing operations
$
(0.10
)
 
$
0.04

Net income (loss)
$
(0.09
)
 
$
0.06


Included in general and administrative expenses, primarily during 2017, are approximately $1.3 million in fees associated with the HCS Acquisition, including $0.9 million in investment advisor fees.


28



Sale of Corvisa LLC . Subject to the terms and conditions of the Membership Interest Purchase Agreement, dated as of December 21, 2015, by and among the Company, Corvisa Services, LLC ("Corvisa") and ShoreTel, Inc. ("Shoretel"), Shoretel agreed to purchase 100% of the membership interests of Corvisa, at the time a wholly-owned subsidiary of the Company. The sale closed on January 6, 2016. During the first quarter of 2017, the Company received $1.0 million from the release of the indemnification escrow which was recorded as a gain and included in discontinued operations during 2017.

Results of Discontinued Operations - The results of the Company's discontinued operations are summarized below (in thousands):
 
For the Year Ended December 31,
 
2017
 
2016
Recognition of gain upon release of indemnification escrow - Corvisa sale
$
1,020

 
$

Gain on sale of Corvisa

 
1,966

Expenses related to discontinued operations
(125
)
 

Income from discontinued operations, net of income taxes
$
895

 
$
1,966


The assets and liabilities of discontinued operations are not material.

Note 5. Accounts and Unbilled Receivables

 
December 31, 2017 (in thousands)
Accounts receivable
$
5,418

Unbilled receivables
2,504

 
 
 
$
7,922


As of December 31, 2017, management has determined no allowance for doubtful accounts is necessary.

Note 6 . Marketable Securities

The Company's portfolio of available-for-sale securities includes (dollars in thousands):
 
Amortized Cost
 
Gross Unrealized
 
Estimated Fair Value
 
 
Gains
 
Losses
 
As of December 31, 2017
Marketable securities, current
 
 
 
 
 
 
 
Mortgage securities
$
400

 
$
11,394

 
$

 
$
11,794

Equity securities
1

 

 

 
1

Total
$
401

 
$
11,394

 
$

 
$
11,795

 
 
 
 
 
 
 
 
As of December 31, 2016
Marketable securities, current
 
 
 
 
 
 
 
Mortgage securities
$
450

 
$
9,341

 
$

 
$
9,791

Equity securities
112

 
47

 
(7
)
 
152

Total
$
562

 
$
9,388

 
$
(7
)
 
$
9,943

 
 
 
 
 
 
 
 
Marketable securities, non-current
 
 
 
 
 
 
 
Agency mortgage-backed securities
$
26,607

 
$

 
$
(62
)
 
$
26,545


See Note 10 for a discussion of the Company's fair value methods and measurements.


29



During 2017, the Company's entire portfolio of agency mortgage-backed securities was sold. Proceeds from the sale were $25.2 million and a gain of $79 thousand recognized, included in other income in the Company's consolidated statements of operations and comprehensive income (loss).

Prior to 2016, the Company originated, purchased, securitized, sold, invested in and serviced residential nonconforming mortgage loans and mortgage securities. As a result of those activities, the Company holds mortgage securities that continue to be a source of its earnings and cash flow. As of December 31, 2017 and 2016 , these mortgage securities consisted entirely of the Company's investment in the residual securities issued by securitization trusts sponsored by the Company. Residual securities consist of interest-only and overcollateralization bonds. There were no other-than-temporary impairments relating to available-for-sale securities for 2017 and 2016. Maturities of retained mortgage securities owned by the Company depend on repayment characteristics and experience of the underlying financial instruments. See Note 10 to the consolidated financial statements for details on the Company's fair value methodology.

The following table relates to the securitizations where the Company retained an interest in the assets issued by the securitization trust (in thousands):
 
Principal Outstanding (A)
 
Assets on Balance Sheet (B)
 
Liabilities on Balance Sheet
 
Maximum Exposure to Loss(B)
 
Year to Date Loss on Sale
 
Year to Date Cash Flows
December 31, 2017
$
2,714,823

 
$
11,794

 
$

 
$
11,794

 
$

 
$
3,193

December 31, 2016
$
3,185,270

 
$
9,791

 
$

 
$
9,791

 
$

 
$
5,153

(A)    Principal Outstanding is the aggregate principal of the underlying loans held by the securitization trusts.
(B)    Assets on Balance Sheet and Maximum Exposure to Loss is the estimated fair value of securities issued by the entity and recorded as marketable securities, current in the consolidated balance sheets.


Note 7. Goodwill and Intangible Assets
 
December 31, 2017 (in thousands)
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net Carrying Amount
Indefinite-lived assets
 
 
 
 
 
Goodwill
$
8,205

 
$

 
$
8,205

Tradenames
1,147

 

 
1,147

 
$
9,352

 
$

 
$
9,352

 
 
 
 
 
 
Finite-lived assets
 
 
 
 
 
Customer relationships
6,895

 
410

 
6,485

Non-compete agreement
627

 
87

 
540

 
$
7,522

 
$
497

 
$
7,025


 
Year Ended December 31, 2017
Goodwill activity (in thousands):
 
Balance, December 31, 2016
$

Goodwill recorded in connection with the HCS Acquisition
12,705

Impairment charge
(4,500
)
 
 
Balance, December 31, 2017
$
8,205


During the fourth quarter of 2017, HCS was notified that a customer was significantly reducing the level of staff outsourced to HCS. The last pay period in 2017 was the final service period for these employees. This customer represented more than 20% of the Company's service fee income during 2017. Accordingly, management completed a goodwill impairment assessment as of December 31, 2017, determined that the carrying value of the HCS goodwill exceeded the fair value by $4.5 million and recorded a goodwill impairment charge for the year ended December 31, 2017. Management assessed the other indefinite and definite lived intangible assets and determined no impairment existed as of December 31, 2017.

30



Amortization expense (in thousands)
 
2017
$
496

Estimated amortization expense (in thousands)
 
2018
1,194

2019
1,194

2020
1,107

2021
985

2022
985

Thereafter
1,560

Total estimated amortization expense
$
7,025


Note 8 . Borrowings

Revolving Credit Agreement. As of December 31, 2017, HCS had $3.3 million outstanding under a Revolving Credit and Security Agreement (the “FNCC Credit Agreement”) between HCS and Federal National Payables, Inc. (d/b/a Federal National Commercial Credit) (“FNCC”) providing HCS with a line of credit of up to $5,000,000 . Availability under the FNCC Credit Agreement is based on a formula tied to HCS’s eligible accounts receivable. Borrowings, and borrowings under the FNCC Credit Agreement bear interest at the prime rate plus 1.25% . The FNCC Credit Agreement also provides for customary origination and collateral monitoring fees payable to FNCC during its term. The initial term of the FNCC Credit Agreement expires on November 17, 2018, but it will be renewed automatically for consecutive one-year terms thereafter unless the FNCC Credit Agreement is
terminated pursuant to its terms. The obligations of HCS under the FNCC Credit Agreement are secured by HCS’s inventory
and accounts receivable.

The FNCC Credit Agreement contains customary representations, warranties and affirmative and negative covenants, including but not limited to financial covenants. The FNCC Credit Agreement also contains customary events of default, including but not limited to payment defaults, cross defaults with certain other indebtedness, breaches of covenants and bankruptcy events. In the case of an event of default, FNCC may, among other remedies, accelerate payment of all obligations under the FNCC Credit Agreement. In connection with the FNCC Credit Agreement, the Company executed a guaranty in favor of FNCC guaranteeing all of HCS’s obligations under the FNCC Credit Agreement.

Note Refinancing and 2017 Notes. Prior to the third quarter of 2017, the Company had outstanding three series of unsecured 2011 Notes pursuant to three separate “Indentures” with an aggregate principal balance of $85.9 million . On July 27, 2017, the Company entered into a Senior Secured Note Purchase Agreement, dated as of the same date (the “Note Purchase Agreement”), with NHI and HCS as guarantors (together with the Company, collectively, the “Credit Parties”), the Noteholders and Wilmington Savings Fund Society, FSB, as collateral agent for the benefit of the Noteholders, to refinance $85.9 million of principal indebtedness of the Company under the 2011 Notes. Pursuant to the Note Purchase Agreement, the Noteholders exchanged their 2011 Notes for new notes from the Company in the same aggregate principal amount (collectively, the “2017 Notes”) on the terms and conditions set forth therein.

Pursuant to the Note Purchase Agreement, in connection with the Note Refinancing, the Company paid all overdue and unpaid accrued interest on the 2011 Notes in the agreed, reduced aggregate amount of $5.8 million , and paid $0.5 million in fees and expenses incurred by the Noteholders.

The unpaid principal amounts of the 2017 Notes bear interest at a variable rate equal to LIBOR plus 3.5% per annum, payable quarterly in arrears until maturity on March 30, 2033. The 2017 Notes generally rank senior in right of payment to any existing or future subordinated indebtedness of the Credit Parties. The Company may at any time upon 30 days’ notice to the Noteholders redeem all or part of the 2017 Notes at a redemption price equal to 101% of the principal amount redeemed plus any accrued and unpaid interest thereon.

The Note Purchase Agreement contains customary affirmative and negative covenants, including but not limited to certain financial covenants. The Note Purchase Agreement also contains customary events of default, including but not limited to payment defaults, cross defaults with certain other indebtedness, breaches of covenants and bankruptcy events. In the case of an event of default, the Noteholders may, among other remedies, accelerate the payment of all obligations under the Note Purchase Agreement and the 2017 Notes. The Credit Parties entered into a Pledge and Security Agreement, dated as of the same date, pursuant to which each of the Credit Parties granted a first priority lien generally covering all of its assets, other than accounts receivable and inventory, for the benefit of the Noteholders, to secure the obligations under the Note Purchase Agreement and the 2017 Notes.

Property Financing. HCS financed the acquisition of property used in its operations under two separate financing agreements. The total amount financed under the agreements was $1.3 million at an aggregate nominal interest rate of 4.1% . The total

31



amount outstanding under these loans was $0.6 million as of December 31, 2017 of which $0.4 million was current and is included in other current liabilities.

Note 9 . Commitments and Contingencies
 
Contingencies . Prior to 2016, the Company originated, purchased, securitized, sold, invested in and serviced residential nonconforming mortgage loans and mortgage securities. The Company has received indemnification and loan repurchase demands with respect to alleged violations of representations and warranties (“defects”) and with respect to other alleged misrepresentations and contractual commitments made in loan sale and securitization agreements. These demands have been received substantially beginning in 2006 and have continued into recent years. Prior to the Company ceasing the origination of loans in its mortgage lending business, it sold loans to securitization trusts and other third parties and agreed to repurchase loans with material defects and to otherwise indemnify parties to these transactions. Beginning in 1997 and ending in 2007, affiliates of the Company sold loans to securitization trusts and third parties with the potential of such obligations. The aggregate original principal balance of these loans was $43.1 billion at the time of sale or securitization. The remaining principal balance of these loans is not available as these loans are serviced by third parties and may have been refinanced, sold or liquidated. Claims to repurchase loans or to indemnify under securitization documents have not been acknowledged as valid by the Company. In some cases, claims were made against affiliates of the Company that have ceased operations and have no or limited assets. The Company has not repurchased any loans or made any such indemnification payments since 2010.

Historically, repurchases of loans or indemnification of losses where a loan defect has been alleged have been insignificant and any future losses for alleged loan defects have not been deemed to be probable or reasonably estimable; therefore, the Company has recorded no reserves related to these claims. The Company does not use internal groupings for purposes of determining the status of these loans. The Company is unable to develop an estimate of the maximum potential amount of future payments related to repurchase demands because the Company does not have access to information relating to loans sold and securitized and the number or amount of claims deemed probable of assertion is not known nor is it reasonably estimated. Further, the validity of claims received remains questionable. Also, considering that the Company completed its last sale or securitization of loans during 2007, the Company believes that it will be difficult for a claimant to successfully validate any additional repurchase demands. Management does not expect that the potential impact of claims will be material to the Company's consolidated financial statements.

Pending Litigation . The Company is a party to various legal proceedings. Except as set forth below, these proceedings are of an ordinary and routine nature. Any legal fees associated with these proceedings are expensed as incurred.

Although it is not possible to predict the outcome of any legal proceeding, in the opinion of management, other than the active proceedings described in detail below, proceedings and actions against the Company should not, individually, or in the aggregate, have a material effect on the Company's financial condition, operations and liquidity. Furthermore, due to the uncertainty of any potential loss as a result of pending litigation and due to the Company's belief that an adverse ruling is not probable, the Company has not accrued a loss contingency related to the following matters in its consolidated financial statements. However, a material outcome in one or more of the active proceedings described below could have a material impact on the results of operations in a particular quarter or fiscal year. See Note 2 to the consolidated financial statements for a description of the impact of the Company's Chapter 11 case on these proceedings.

On May 21, 2008, a purported class action case was filed in the Supreme Court of the State of New York, New York County, by the New Jersey Carpenters' Health Fund, on behalf of itself and all others similarly situated. Defendants in the case included NovaStar Mortgage Funding Corporation (“NMFC”) and NovaStar Mortgage, Inc. ("NMI"), wholly-owned subsidiaries of the Company, and NMFC's individual directors, several securitization trusts sponsored by the Company (“affiliated defendants”) and several unaffiliated investment banks and credit rating agencies. The case was removed to the United States District Court for the Southern District of New York. On June 16, 2009, the plaintiff filed an amended complaint. The plaintiff seeks monetary damages, alleging that the defendants violated sections 11, 12 and 15 of the Securities Act of 1933, as amended, by making allegedly false statements regarding mortgage loans that served as collateral for securities purchased by the plaintiff and the purported class members. On August 31, 2009, the Company filed a motion to dismiss the plaintiff's claims, which the court granted on March 31, 2011, with leave to amend. The plaintiff filed a second amended complaint on May 16, 2011, and the Company again filed a motion to dismiss. On March 29, 2012, the court dismissed the plaintiff's second amended complaint with prejudice and without leave to replead. The plaintiff filed an appeal. On March 1, 2013, the appellate court reversed the judgment of the lower court, which had dismissed the case. Also, the appellate court vacated the judgment of the lower court which had held that the plaintiff lacked standing, even as a class representative, to sue on behalf of investors in securities in which plaintiff had not invested, and the appellate court remanded the case back to the lower court for further proceedings. On April 23, 2013 the plaintiff filed its memorandum with the lower court seeking a reconsideration of the earlier dismissal of plaintiff's claims as to five offerings in which plaintiff was not invested, and on February 5, 2015 the lower court granted plaintiff's motion for reconsideration and vacated its earlier dismissal. On March 8, 2017, the affiliated defendants and all other parties executed an agreement to settle the action, with the contribution of the affiliated defendants to the settlement fund being paid by their insurance carriers. The court certified a settlement class and granted preliminary approval to the settlement on May 10, 2017.  One member of the settlement class objected to the settlement and sought a stay of the final settlement approval hearing on the ground that it did not receive notice of the settlement and had no opportunity to timely opt out of the class.  After the court

32



rejected the motion for a stay, the objector filed an appeal and requested a stay of the district court proceedings pending disposition of the appeal. The court of appeals denied the temporary stay of the district court proceedings pending a decision
on the objector’s request for a stay. Assuming the settlement is approved and completed, which is expected, the Company will incur no loss. The Company believes that the affiliated defendants have meritorious defenses to the case and, if the settlement is not approved, expects them to defend the case vigorously.

On June 20, 2011, the National Credit Union Administration Board, as liquidating agent of U.S. Central Federal Credit Union, filed an action against NMFC and numerous other defendants in the United States District Court for the District of Kansas, claiming that the defendants issued or underwrote residential mortgage-backed securities pursuant to allegedly false or misleading registration statements, prospectuses, and/or prospectus supplements. On August 24, 2012, the plaintiff filed an amended complaint making essentially the same claims against NMFC. NMFC filed a motion to dismiss the amended complaint which was denied on September 12, 2013. The defendants had claimed that the case should be dismissed based upon a statute of limitations and sought an appeal of the court's denial of this defense. An interlocutory appeal of this issue was allowed, and on August 27, 2013, the Tenth Circuit affirmed the lower court’s denial of defendants’ motion to dismiss the plaintiff’s claims as being time barred; the appellate court held that the Extender Statute, 12 U.S.C. §1787(b)(14) applied to plaintiff’s claims. On June 16, 2014, the United States Supreme Court granted a petition of NMFC and its co-defendants for certiorari, vacated the ruling of the Tenth Circuit, and remanded the case back to that court for further consideration in light of the Supreme Court’s decision in CTS Corp. v. Waldburger, 134 S. Ct. 2175 (2014). On August 19, 2014, the Tenth Circuit reaffirmed its prior decision, and on October 2, 2014 the defendants filed a petition for writ of certiorari with the Supreme Court, which was denied. On March 22, 2016, NMFC filed motions for summary judgment, and plaintiff filed a motion for partial summary judgment. Those motions remain pending. Given that plaintiff did not file a timely proof of claim in NMFC’s bankruptcy case, the Company believes it is likely that the case will be dismissed. The Company and NMFC have meritorious defenses to the case and expects it to defend the case vigorously in the event it proceeds.

On February 28, 2013 the Federal Housing Finance Agency, as conservator for the Federal Home Loan Mortgage Corporation (Freddie Mac) and purportedly on behalf of the Trustee of the NovaStar Mortgage Funding Trust, Series 2007-1 (the “Trust”), a securitization trust in which the Company retains a residual interest, filed a summons with notice in the Supreme Court of the State of New York, County of New York against the Company and NMI. The notice provides that this is a breach of contract action with respect to certain, unspecified mortgage loans and defendants' failure to repurchase such loans under the applicable agreements. Plaintiff alleges that defendants, from the closing date of the transaction that created the Trust, were aware of the breach of the representations and warranties made and failed to give notice of and cure such breaches, and due to the failure of defendants to cure any breach, notice to defendants would have been futile. The summons with notice was not served until June 28, 2013. By letter dated June 24, 2013, the Trustee of the Trust forwarded a notice from Freddie Mac alleging breaches of representations and warranties with respect to 43 loans, as more fully set forth in included documentation. The 43 loans had an aggregate, original principal balance of about $6.5 million . On August 19, 2013, Deutsche Bank National Trust Company, as Trustee, filed a complaint identifying alleged breaches of representations and warranties with respect to seven loans that were included in the earlier list of 43 loans. Plaintiff also generally alleged a trust-wide breach of representations and warranties by defendants with respect to loans sold and transferred to the trust. Plaintiff seeks specific performance of repurchase obligations; compensatory, consequential, recessionary and equitable damages for breach of contract; specific performance and damages for anticipatory breach of contract; indemnification (indemnification against NMI only) and damages for breach of the implied covenant of good faith and fair dealing. On October 9, 2013, the Company and NMI filed a motion to dismiss plaintiff’s complaint. This motion to dismiss was withdrawn after plaintiff filed an amended complaint on January 28, 2014, and on March 4, 2014 the Company and NMI filed a motion to dismiss the amended complaint. By a Decision/Order dated November 30, 2017, the court granted in part and denied in part the motion to dismiss the amended complaint. The court dismissed all claims except for plaintiff’s claim for damages for breach of contract, to the extent that claim is based on the Company’s and NMI’s alleged failure to notify plaintiff of allegedly defective loans, and plaintiff’s claim for indemnification. The court denied the motion to dismiss these claims without prejudice to the Company’s and NMI’s right to file a new motion to dismiss in conformity with procedures to be established in coordinated proceedings before the court addressing similar claims against numerous defendants. Briefing of the indemnification issues is now underway. Given the stage of the litigation, the Company cannot provide an estimate of the range of any loss. The Company believes it has meritorious defenses to the case and expects to defend the case vigorously.

Note 10 . Fair Value Accounting

Fair Value Measurements

The Company's valuation techniques are based upon observable and unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company's market assumptions. These two types of inputs create the following fair value hierarchy:

Level 1 – Valuations based on quoted prices in active markets for identical assets and liabilities.
Level 2 – Valuations based on observable inputs in active markets for similar assets and liabilities, other than Level 1 prices, such as quoted interest or currency exchange rates for substantially the full term of the asset or liability.
Level 3 – Valuations based on significant unobservable inputs that are supported by little or no market activity, such as discounted cash flow methodologies based on internal cash flow forecasts.


33



The following tables present for each of the fair value hierarchy levels, the Company's assets and liabilities which are measured at fair value on a recurring basis (in thousands):
 
 
 
Fair Value Measurements at Reporting Date Using
 
Fair Value
 
Quoted Prices in Active Markets for Identical Assets
(Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
December 31, 2017
 
 
 
 
 
 
 
Marketable securities, current
$
11,795

 
$
1

 
$


$
11,794

December 31, 2016
 
 
 
 
 
 
 
Marketable securities, current
$
9,943

 
$
152

 
$

 
$
9,791

Marketable securities, non-current
26,545

 
26,545

 

 

 
$
36,488

 
$
26,697

 
$

 
$
9,791


Valuation Methods and Processes

When available, the Company determines the fair value of its marketable securities using market prices from industry-standard independent data providers. Market prices may be quoted prices in active markets for identical assets (Level 1 inputs) or pricing determined using inputs other than quoted prices that are observable either directly or indirectly (Level 2 inputs), such as yield curve, volatility factors, credit spreads, default rates, loss severity, current market and contractual prices for the underlying instruments or debt, broker and dealer quotes, as well as other relevant economic measures.

To the extent observable inputs are not available, as is the case with the Company's retained mortgage securities, the Company estimates fair value using present value techniques and generally does not have the option to choose other valuation methods for these securities. The methods and processes used to estimate the fair value of the Company's retained mortgage securities are discussed further below. There have been no significant changes to the Company's valuation techniques. Accordingly, there have been no material changes to the consolidated financial statements resulting from changes to our valuation techniques.

The Company's marketable securities are classified as available-for-sale and are reported at their estimated fair value with unrealized gains and losses reported in accumulated other comprehensive income. To the extent that the cost basis of the Company's marketable securities exceeds the fair value and the unrealized loss is considered to be other than temporary, an impairment charge is recognized and the amount recorded in accumulated other comprehensive income or loss is reclassified to earnings as a realized loss. The specific identification method is used in computing realized gains or losses.

Mortgage securities - available-for-sale . The Company's mortgage securities include traditional agency mortgage-backed securities, with valuations based on quoted prices in active markets for identical assets (Level 1). Additionally, mortgage securities include investments that were retained during the Company's lending and securitization process, conducted prior to 2016. For the retained mortgage securities, the Company maintains the right to receive excess interest and other cash flow generated through the mortgage loan securitization vehicle. The Company receives the difference between the interest on the mortgage loans and the interest paid to the securitization bondholders. The Company also owns overcollateralization ("OC") classes of various securitization trusts. These OC bonds represent the difference in the principal of the underlying mortgage loans compared to the bonds sold to third parties. This extra collateral serves as a cushion for losses that have and may occur in the underlying mortgage pool. The OC bonds may receive cash if and when it is determined that actual losses are less than expectations. As of December 31, 2017 , the aggregate overcollateralization was $27.0 million . The timing and amount of cash to be generated by the OC bonds is contingent upon the performance of the underlying mortgage loan collateral.

The independent loan servicer controls and manages the individual mortgage loans and therefore the Company has no control over the loan performance. Collectively, these mortgage securities are identified by the Company as "retained mortgage securities," in order to distinguish them from the Company's traditional agency mortgage-backed securities. Retained mortgage-backed securities are valued at each reporting date using significant unobservable inputs (Level 3) by discounting the expected cash flows. An independent valuation specialist has been engaged to assist management in estimating cash flows and values for the Company's mortgage securities. It is the Company's responsibility for the overall resulting valuation.

As discussed in Note 1 , the Company sold a portion of its retained mortgage securities subsequent to December 31, 2017. The Company evaluated the market conditions and other factors existing at the time of the sale as compared to December 31, 2017 and determined that conditions were substantially the same as of the sale date and December 31, 2017. Therefore, as of December 31, 2017 the Company valued these securities at the price at which it was sold. However, the Company determined that it could not extrapolate that price to the other retained mortgage securities because the underlying assets and their performance are not substantially similar to that of the security that was sold. Therefore, the other mortgage securities have been valued as discussed below.

The critical assumptions used in estimating the value of the mortgage securities include market interest rates, rate and severity of default, prepayment speeds and how long the security will continue to provide cash flow. To determine the assumptions, the

34



Company and its independent valuation specialist rely primarily on historical mortgage loan performance and appropriate general economic indicators. The Company continuously reviews the assumptions used and monitors the efforts of the independent valuation specialist. The significant unobservable inputs used in preparing the fair value estimates are:
 
As of December 31,
 
2017
2016
Weighted average:
 
 
Loss severity
62.1
%
49.6
%
Default rate
2
%
2.1
%
Prepayment speed
13.5
%
9.8
%
Servicer's optional redemption date
None
None

The following table provides a reconciliation of the beginning and ending balances for the Company's retained mortgage securities – available-for-sale which are measured at fair value on a recurring basis using significant unobservable inputs (Level 3) (in thousands):
 
For the Year Ended
December 31,
 
2017
 
2016
Balance, beginning of period
$
9,791

 
$
2,011

Increases (decreases) to mortgage securities – available-for-sale:
 
 
 
Proceeds from paydowns of securities, net (A)
(51
)
 
(75
)
Mark-to-market value adjustment
2,054

 
7,855

Net increases (decreases) to mortgage securities – available-for-sale
2,003

 
7,780

Balance, end of period
$
11,794

 
$
9,791

(A)
Cash received on mortgage securities with no cost basis was $2.8 million and $4.7 million during 2017 and 2016 , respectively.

The following disclosure of the estimated fair value of financial instruments presents amounts that have been determined using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that could be realized in a current market exchange. The use of different market assumptions or estimation methodologies could have a material impact on the estimated fair value amounts. The fair value of short-term financial assets and liabilities, such as service fees receivable, accounts payable and accrued expenses are not included in the following table as their fair value approximates their carrying value.

The estimated fair values of the Company's financial instruments are as follows as of December 31, 2017 and 2016 (in thousands):  
 
As of December 31,
 
2017
 
2016
 
Carrying Value
 
Fair Value
 
Carrying Value
 
Fair Value
Financial assets:
 
 
 
 
 
 
 
Marketable securities
$
11,795

 
$
11,795

 
$
36,488

 
$
36,488

Financial liabilities:
 
 
 
 
 
 
 
Senior notes
$
85,938

 
$
23,018

 
$
85,938

 
$
23,349


For the items in the table above not measured at fair value in the consolidated balance sheets but for which the fair value is disclosed, the fair value has been estimated using Level 3 methodologies, based on significant unobservable inputs that are supported by little or no market activity, such as discounted cash flow calculations based on internal cash flow forecasts. No assets or liabilities have been transferred between levels during any period presented.

Senior Notes. The fair value is estimated by discounting future projected cash flows using a discount rate commensurate with the risks involved. The interest rate on the senior notes is three-month LIBOR plus  3.5% per annum until maturity in March 2033. The three-month LIBOR used in the analysis was projected using a forward interest rate curve.

Financial assets reported at fair value on a nonrecurring basis include the following (in thousands):

35



 
December 31, 2017
 
Fair Value (Level 3)
 
Gains and (Losses)
Goodwill
$
8,205

 
$
(4,500
)

Activity during 2017 for Goodwill, the Company's only Level 3 asset, measured on a nonrecurring basis is included in the following table (in thousands):
Goodwill
 
Balance, December 31, 2016
$

Goodwill recorded in connection with the HCS Acquisition
12,705

Impairment charge
(4,500
)
Balance, December 31, 2017
$
8,205


See note 7 for additional information regarding the Company's Goodwill and Intangible Assets.

Note 11 . Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing net earnings (loss) available to common shareholders by the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share include the effect of conversions of stock options and nonvested shares. The computations of basic and diluted earnings per share for 2017 and 2016 (dollars in thousands, except share and per share amounts) are as follows:
 
For the Year Ended
December 31,
 
2017
 
2016
Numerator:
 
 
 
Net income (loss) from continuing operations
$
(11,760
)
 
$
3,247

Income (loss) from discontinued operations
895

 
1,966

Net income (loss)
$
(10,865
)
 
$
5,213

Denominator:
 
 
 
Weighted average common shares outstanding – basic
92,800,392

 
91,905,941

 
 
 
 
Weighted average common shares outstanding – diluted:
 
 
 
Weighted average common shares outstanding – basic
92,800,392

 
91,905,941

Stock options

 

Nonvested shares

 

Weighted average common shares outstanding – diluted
92,800,392

 
91,905,941

Basic earnings per share:
 
 
 
Net income (loss) from continuing operations
$
(0.13
)
 
$
0.04

Income (loss) from discontinued operations
0.01

 
0.02

Net income (loss)
$
(0.12
)
 
$
0.06

Diluted earnings per share:
 
 
 
Net income (loss) from continuing operations
$
(0.13
)
 
$
0.04

Income (loss) from discontinued operations
0.01

 
0.02

Net income (loss)
$
(0.12
)
 
$
0.06



36



The following weighted-average stock options to purchase shares of common stock were outstanding, but were not included in the computation of diluted earnings (loss) per share because the number of shares assumed to be repurchased, as calculated was greater than the number of shares to be obtained upon exercise, therefore, the effect would be antidilutive. There were no options granted during 2016 and 2017.
 
For the Year Ended
December 31,
 
2017
 
2016
Number of stock options
1,411

 
4,719

Weighted average exercise price of stock options
$
0.89

 
$
0.68


During 2016, the Company granted 0.1 million nonvested shares to a director and these shares vested in 2016. During 2017, the Company granted 4.3 million shares to directors, officers and other members of management. Substantially all of these shares will vest in 2018, assuming the grantees are employed at the vest date. As of December 31, 2017 and 2016, respectively, the Company had approximately 4.3 million and 0.1 million nonvested shares outstanding. The weighted average impact of 1.1 million and 0.9 million nonvested shares were not included in the calculation of earnings per share for 2017 and 2016, respectively, because they were anti-dilutive.

Note 12 . Income Taxes

The components of income tax expense (benefit) from continuing operations are (in thousands):
 
For the Year Ended
December 31,
 
2017
 
2016
Current:
 

 
 

Federal
$
(1
)
 
$
(14
)
State and local
15

 
(7
)
Total current
$
14

 
$
(21
)

Below is a reconciliation of the expected federal income tax expense (benefit) using the federal statutory tax rate of 35% to the Company’s actual income tax benefit and resulting effective tax rate (in thousands).
 
For the Year Ended
December 31,
 
2017
 
2016
Income tax (benefit) at statutory rate
$
(3,802
)
 
$
1,129

 
 
 
 
State income taxes, net of federal tax benefit
(54
)
 
211

Valuation allowance
(131,234
)
 
14,595

Change in federal tax rate
33,640

 

Change in state tax rate
100,899

 
(16,475
)
Bankruptcy reorganization
746

 
437

Uncertain tax positions
(4
)
 
(35
)
Other
(177
)
 
117

Total income tax expense (benefit)
$
14

 
$
(21
)

In 2017, the federal statutory rate for periods beginning after December 31, 2017 was changed to 21%. This change in rate caused a significant change to the Company's deferred tax assets as they pertain to its net operating losses ("NOLs"). The 2017 change in deferred tax assets related to the federal NOLs was $100.9 million in the current year. This was offset by a decrease in the valuation allowance by $100.9 million . Prior to 2016, the Company concluded that it was no longer more likely than not that it would realize a portion of its deferred tax assets. Therefore, the Company maintained a full valuation allowance against its net deferred tax assets as of both December 31, 2017 and 2016.

The Company's determination of the realizable deferred tax assets requires the exercise of significant judgment, based in part on business plans and expectations about future outcomes. In the event the actual results differ from these estimates in future periods, the Company may need to adjust the valuation allowance, which could materially impact our financial position and results of operations. The Company will continue to assess the need for a valuation allowance in future periods. As of December

37



31, 2017 and 2016, the Company maintained a valuation allowance of $162.7 million and $292.2 million , respectively, for its deferred tax assets.

In 2017, due to the purchase of HCS, the Company reassessed their state apportionment rates. Based on available information, the Company changed the apportionment factors, specifically the apportionment factor used for allocation of income to the State of Missouri. In this reassessment, the Company determined that as of December 31, 2017 it was no longer appropriate to apportion 100% of the Federal NOL to the state of Missouri, but rather the company would apportion approximately 13% . As a result of this reassessment, the Company recalculated the deferred tax assets which resulted in the reduction of the deferred tax asset related to state NOLs totaling approximately $33.6 million in the current year. This was offset by a decrease in the valuation allowance of approximately $33.6 million . Significant components of the Company’s deferred tax assets and liabilities are (in thousands):
 
December 31,
 
2017
 
2016
Deferred tax assets:
 
 
 
Basis difference – investments
$
8,015

 
$
17,261

Federal NOL carryforwards
145,608

 
239,942

State NOL carryforwards
8,301

 
35,896

Other
2,756

 
2,816

Gross deferred tax asset
164,680

 
295,915

Valuation allowance
(162,708
)
 
(292,214
)
Deferred tax asset
1,972

 
3,701

Deferred tax liabilities:
 
 
 
Other
1,972

 
3,701

Deferred tax liability
1,972

 
3,701

Net deferred tax asset
$

 
$


As of December 31, 2017 , the Company had a federal NOL of approximately $692.0 million , including $307.3 million in losses on mortgage securities that have not been recognized for income tax purposes. The federal NOL may be carried forward to offset future taxable income, subject to applicable provisions of the Internal Revenue Code (the "Code"). If not used, these NOLs will expire in years 2025 through 2037 . The Company has state NOL carryforwards arising from both combined and separate filings from as early as 2004. The state NOL carryforwards may expire as early as 2017 and as late as 2037 .

The activity in the accrued liability for unrecognized tax benefits, included in other current liabilities, was (in thousands):
 
For the Year Ended
December 31,
 
2017
 
2016
Beginning balance
$
331

 
$
368

Gross increases – tax positions in current period
22

 
2

Lapse of statute of limitations
(25
)
 
(39
)
Ending balance
$
328

 
$
331


As of December 31, 2017 and 2016 , the total gross amount of unrecognized tax benefits was $0.3 million , which also represents the total amount of unrecognized tax benefits that would impact the effective tax rate. The Company anticipates a reduction of unrecognized tax benefits of less than $0.1 million due the lapse of statute of limitations in the next twelve months. The Company does not expect any other significant change in the liability for unrecognized tax benefits in the next twelve months. It is the Company’s policy to recognize interest and penalties related to income tax matters in income tax expense. The benefit for interest and penalties recorded in income tax expense was not significant for 2017 and 2016 . There were accrued interest and penalties of less than $0.1 million as of both December 31, 2017 and 2016 . The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of multiple state and local jurisdictions. Tax years 2013 to 2017 remain open to examination for both U.S. federal income tax and major state tax jurisdictions.

38




Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
None.

Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this report, our executive chairman and our chief financial officer conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based on their evaluation of our disclosure controls and procedures, our executive chairman and chief financial officer, with the participation of the Company’s management, concluded that our disclosure controls and procedures were not effective as of December 31, 2017, to ensure that information required to be disclosed by the Company in the reports that we file or submit under the Exchange Act is (a) recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and (b) accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow for timely decisions regarding required disclosure.

Management’s Annual Report on Internal Control over Financial Reporting

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting
as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Our internal control over financial reporting is
designed to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of consolidated
financial statements for external purposes in accordance with GAAP. Under the supervision and with the participation of
management, including the Company’s principal executive officer and principal financial officer, the Company conducted an
evaluation of the effectiveness of its internal control over financial reporting as of December 31, 2017 based on the framework
set forth in Internal Control—Integrated Framework (2013), issued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on that evaluation and its assessment, management concluded that the Company’s internal
control over financial reporting was not effective as of December 31, 2017.

Description of Material Weakness
 
As discussed in Management's Discussion and Analysis of Financial Condition and Results of Operations above and in Note 4 to our accompanying consolidated financial statements, in July 2017, we acquired HCS, which now is our primary business activity. Prior to the HCS Acquisition, HCS was a privately-owned business with limited administrative and accounting resources, accounting software inappropriate for the size of the business and generally weak accounting processes, procedures and controls. Specifically, material weaknesses existed in HCS's processes, procedures and controls with respect to revenue, receivables, payment of payroll taxes and estimating various accrued expenses.

Remediation of Material Weakness

We are working to improve the processes, procedures and controls at HCS and remediate this material weakness. Since the HCS Acquisition in July 2017, we have implemented improvements in processes, procedures and controls and we will continue to do so. We are evaluating the accounting professionals at the Company and HCS and will determine if additional resources with relevant experience are needed. We will disclose in future periods the progress we have made in efforts to remediate this material weakness.

Changes in Internal Control Over Financial Reporting

As a result of the HCS acquisition and the generally weak controls at HCS discussed above, we determined that we have a material weakness in our disclosure controls and procedures and internal control over financial reporting. We are working to remediate this material weakness as discussed above.

It should be noted that any system of controls, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system will be met. In designing and operating a control system, one must consider the potential benefits of controls relative to their costs and the reality of limited resources available to allocate to control activities, particularly in smaller companies. In addition, the design of any control system is based in part upon certain assumptions about the likelihood of future events and there can be no assurance that any control will meet its objectives under all potential future conditions. Because of such inherent limitations in any control system, there can be no absolute assurance that control issues, misstatements, and/or fraud will be prevented or detected.

Item 9B. Other Information
 
None.

39




PART III

Item 10. Directors, Executive Officers and Corporate Governance

DIRECTORS AND EXECUTIVE OFFICERS

Howard M. Amster , age 70, has been a member of the Board since 2009. Mr. Amster currently is an owner and operator of
multiple real estate investments. Since March 1998, Mr. Amster has served as President of Pleasant Lake Apts. Corp., the
corporate general partner of Pleasant Lake Apts. Limited Partnership. Mr. Amster also serves as a director of Maple Leaf
Financial, Inc., the holding company for Geauga Savings Bank, and newAX, Inc. (formerly Astrex, Inc.). Since June 2015, Mr. Amster also has served as a Financial Advisor at McDonald Partners, LLC, a securities brokerage firm. From 2000 to May 2015, Mr. Amster served as a Principal with Ramat Securities Ltd., a securities brokerage firm. From 1992 to 2000, Mr. Amster was an investment consultant with First Union Securities (formerly EVEREN Securities and formerly Kemper Securities). The Board believes Mr. Amster’s qualifications to serve on the Board include his investment experience and his service as a director of public companies.
 
Charles M. Gillman , age 48, has been a member of the Board since January 2016. Mr. Gillman is the head of the IDWR Multi-Family Office (“IDWR”), a position he has held since 2013. IDWR employs a team of analysts with expertise in finding publicly traded companies that require operational enhancement and an improvement in corporate capital allocation. From 2001 to 2013, Mr. Gillman was a portfolio manager of certain family office investment portfolios at Nadel and Gussman, LLC. Prior to his employment at Nadel and Gussman, Mr. Gillman worked in the investment industry and as a strategic management consultant at McKinsey & Company, where he gained experience designing operational turnarounds of U.S. and international companies. Mr. Gillman currently serves on the board of directors of Points International, Digirad and Solitron. Mr. Gillman is a Summa Cum Laude graduate of the Wharton School and a Director of the Penn Club of New York which serves as the Manhattan home of the Wharton and Penn alumni community. The Board believes that Mr. Gillman’s qualifications to serve on the Board include his significant experience as a successful portfolio manager, M&A experience and divestiture experience.

Barry A. Igdaloff , age 63, has been a member of the Board since 2009. Mr. Igdaloff served as the sole proprietor of Rose Capital, a registered investment advisor in Columbus, Ohio, since 1995. Mr. Igdaloff has been a director of Dynex Capital, Inc. since 2000. Previously, Mr. Igdaloff was a director of Guest Supply, Inc. prior to its acquisition by Sysco Foods in 2001.  Prior to entering the investment business, Mr. Igdaloff was an employee of Ernst & Whinney’s international tax department.  Mr. Igdaloff is a non-practicing CPA and a non-practicing attorney. The Board believes Mr. Igdaloff’s qualifications to serve on the Board include his financial expertise, his years of experience as an investment advisor, attorney, and CPA and his service as a director of public companies.

Robert G. Pearse , age 58, has been a member of the Board since April 2015. Mr. Pearse currently serves as a Managing Partner at Yucatan Rock Ventures, where he specializes in technology investments and consulting, and has served in that position since August 2012. Mr. Pearse serves as a director for Ameri Holdings, Inc. (OTC:AMRH), Chairman of the
Compensation Committee and member of the Audit Committee since May 2015. Previously, Mr. Pearse served as Chairman of the Board of directors for Crossroads Systems, Inc. (NASDAQ:CRDS) from May 2016 to October 2017, and chairman of the Compensation Committee and member of the Audit Committee and the Nomination and Governance Committee from July 2013 to October 2017. Mr. Pearse served as a director for Aviat Networks, Inc. (NASDAQ:AVNW), and member of the Compensation Committee and the Nominating and Governance Committee from January 2015 to November 2016. From 2005 to 2012, Mr.
Pearse served as vice president of Strategy and Market Development at NetApp, Inc. (NASDAQ:NTAP), a computer storage and data management company. From 1987 to 2004, Mr. Pearse held leadership positions at Hewlett-Packard Inc. (NYSE:HPQ), most recently as the vice president of Strategy and Corporate Development from 2001 to 2004. Mr. Pearse’s professional experience also includes positions at PricewaterhouseCoopers LLP, Eastman Chemical Company (NYSE:EMN), and General Motors Company (NYSE:GM). Mr. Pearse earned a Master of Business Administration degree from the Stanford Graduate School of Business in 1986, and a Bachelor of Science degree in Mechanical Engineering from the Georgia Institute of Technology in 1982. The Board believes Mr. Pearse’s qualifications to serve on the Board include his extensive business development and financial expertise.

David W. Pointer, age 48, has been our Chief Executive Officer and Chairman of the Board since March 27, 2018. He
has served as the Managing Partner of V.I. Capital Management, LLC, a registered investment advisory firm that he founded, since January 2008. Prior to that, Mr. Pointer was a Senior Portfolio Manager and Senior Vice President at ICM Asset Management, an employee owned investment manager, from September 2003 to September 2007, as well as Portfolio Manager at AIM/INVESCO Investments, an investment management firm, from July 1999 to August 2003. Mr. Pointer has served on the Board of Directors of CompuMed, Inc., an enterprise telemedicine solutions company, since December 2013 and as Chairman since October 2014, and as Co-Chief Executive Officer from November 2015 to January 2016. He also has served on the Board of Directors of Solitron Devices, Inc., a manufacturer of solid-state semiconductor components, since August 2015 and as Chairman since July 2016. Previously, Mr. Pointer served on the Board of Directors of ALCO Stores, Inc., a retailer, from September 2014 to June 2015. Mr. Pointer has taught Corporate Finance as an adjunct faculty in Whitworth University’s MBA program as well as Gonzaga University’s MBA program and is an expert in financial analysis and financial markets. Mr. Pointer holds a Bachelor of Science in Business Administration from Central Washington University and a Master of Business

40



Administration from the Wharton School of Business at the University of Pennsylvania. Mr. Pointer is a member of the CFA Institute and a Chartered Financial Analyst.

Carolyn K. Campbell , age 47, has served as our Chief Financial Officer since August 2017. She previously worked as an independent contractor in internal audit and tax roles for various businesses from July 2016 to August 2017. From 2007 to March 2016, Ms. Campbell served as the Company’s Internal Audit Manager and was responsible for overseeing corporate audit processes and developing and implementing risk-based audit plans and internal controls over financial recordkeeping and reporting. From 2001 to 2004, Ms. Campbell was an internal auditor with Butler Manufacturing Company, a construction engineering company. From 1995 to 2001, Ms. Campbell was employed by Houlihan’s Restaurant Group, a developer of restaurant concepts, most recently as a tax analyst. Ms. Campbell holds a Bachelor of Science in Business Administration from the University of Central Missouri.

Richard M. Rector , age 61, is the President of HCS. Mr. Rector has more than 30 years of experience in Staffing and Business
Management of mid-size to large businesses. Prior to joining HCS in October 2015, Mr. Rector was Executive Vice President and Co-Owner of an international modernization and staffing company for ten years. Before that, he served as a Regional Manager for two mid-sized companies in the staffing industry. He has extensive experience in business administration, staffing, operations, and automation. Mr. Rector has a Bachelor of Business Administration in Administrative Management and Marketing from the University of North Texas.

CORPORATE GOVERNANCE AND RELATED MATTERS
 
Board Leadership Structure
 
The Board is led by Mr. Pointer, the Company's Chief Executive Officer and Chairman of the Board, and by Mr. Igdaloff, who serves as the Company's Lead Independent Director having such responsibilities set forth in the Company's' Corporate Governance Guidelines. The Board has determined that this leadership structure is in the best interests of the Company’s shareholders at this time.

Board and Committee Meetings
 
During 2017, there were 4 meetings of the Board, 2 meetings of the Audit Committee, 2 meetings of the Compensation Committee and no meetings of the Nominating and Corporate Governance Committee, in addition to actions taken by unanimous written consent. Each director participated in at least 75% of the meetings of the Board and the committees on which he served during the periods for which he has been a director or committee member. We have no written policy regarding director attendance at our annual meetings of shareholders.

Board Committees
 
The Board has a standing Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee. The Board has determined that all directors serving on the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee are independent with the meaning of SEC and NASDAQ rules. Descriptions of the responsibilities of such committees are provided below.  These descriptions are qualified in their entirety by the full text of the written committee charters that may be found on the Company’s website at www.novationcompanies.com.
 
Audit Committee.   The responsibilities of the Audit Committee are set forth in its charter and include assisting the Board in fulfilling its oversight responsibility relating to: (i) the integrity of the Company’s consolidated financial statements and financial reporting process and its system of internal accounting and financial controls; (ii) the performance of the internal audit function; (iii) the performance of the independent auditors, which would include an evaluation of the independent auditor’s qualifications and independence; (iv) the Company’s compliance with legal and regulatory requirements, including disclosure controls and procedures; and (v) the preparation of an Audit Committee report to be included in the Company’s annual proxy statement.  The Audit Committee consists of Barry A. Igdaloff, Howard M. Amster, and Robert G. Pearse, with Mr. Igdaloff serving as the chairman.  The Board has determined that Barry A. Igdaloff and Robert G. Pearse qualify as “audit committee financial experts” under SEC rules and that each Audit Committee member has sufficient knowledge in reading and understanding the Company’s consolidated financial statements to serve on the Audit Committee.
 
Nominating and Corporate Governance Committee.   The responsibilities of the Nominating and Corporate Governance Committee are set forth in its charter and include the following: (i) identify individuals qualified to become Board members consistent with the criteria established by the Board; (ii) recommend to the Board the director nominees for the next annual meeting of shareholders; (iii) lead the Board in the annual review of the Board’s performance and the review of management’s performance; and (iv) shape the corporate governance policies and practices including developing a set of corporate governance principles applicable to the Company and recommending them to the Board.  The Nominating and Corporate Governance Committee consists of Barry A. Igdaloff, Howard M. Amster and Robert G. Pearse, with Mr. Igdaloff serving as the chairman.
 

41



Compensation Committee .  The responsibilities of the Compensation Committee are set forth in its charter and include the following: (i) review and approve the goals, objectives and compensation structure for our Chief Executive Officer, Chief Financial Officer and senior management; (ii) review, approve and recommend to the Board any new incentive-compensation and equity-based plans that are subject to Board approval; and (iii) approve any required disclosure on executive officer compensation for inclusion in the Company’s annual proxy statement and Annual Report on Form 10-K.  The Compensation Committee consists of Robert G. Pearse, Howard M. Amster and Charles M. Gillman, with Mr. Pearse serving as the chairman.
 
Compensation Committee Process and Advisors
 
The Compensation Committee is responsible for discharging the responsibilities of the Board with respect to the compensation of our executive officers. The Compensation Committee recommends overall compensation of our executive officers to the Board. The Board approves all compensation of our executive officers. The Compensation Committee may form and delegate authority to subcommittees, comprised of one or more members of the Compensation Committee, as necessary or appropriate, and each such subcommittee shall have the full power and authority of the Compensation Committee.
 
The charter of the Compensation Committee permits the Compensation Committee to engage outside consultants. In 2017, the Compensation Committee did not retain a compensation consultant.
 
Corporate Governance Documents
 
The Company’s Corporate Governance Guidelines, Code of Conduct, and the charters of the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee are available at the Investors-Corporate Governance section of our website, www.novationcompanies.com.  The Company will also provide copies of these documents free of charge to any shareholder who sends a written request to: Novation Companies, Inc., Investor Relations, 500 Grand Boulevard, Suite 201B, Kansas City, MO 64106.

Code of Ethics

The Company has adopted a Code of Conduct that applies to our directors, principal executive officer, principal financial officer, principal accounting officer, and other employees. The Code of Conduct is available at the Investors-Corporate Governance section of our website, www.novationcompanies.com. We intend to satisfy the disclosure requirements regarding any amendment to, or waiver from, a provision of our Code of Conduct that applies to our principal executive officer, principal financial officer, principal accounting officer, controller or persons performing similar functions by disclosing such matters on our website within four business days.
 
Our investor relations contact information follows:
 
Investor Relations
500 Grand Boulevard, Suite 201B
Kansas City, Missouri 64106
816.237.7000
Email:  ir@novationcompanies.com
 
Shareholder Communications with the Board
 
Shareholders may communicate directly with any member of the Board or any individual chairman of a Board committee by writing directly to those individuals at the following address: Novation Companies, Inc., 500 Grand Boulevard, Suite 201B, Kansas City, MO 64106. Communications that are intended for the non-management, independent directors generally should be marked to the attention of the chairman of the Nominating and Corporate Governance Committee.  The Company’s general policy is to forward, and not to intentionally screen, any substantive mail received at the Company’s corporate office that is sent directly to a director; however, (i) routine advertisements and business solicitations and (ii) communications deemed to be a security risk or principally for harassment purposes, may not be forwarded in the discretion of the Corporate Secretary, provided that in the latter case the Chairman of the Board is notified thereof.

Risk Oversight
 
The Board oversees an enterprise-wide approach to risk management, designed to support the achievement of Company objectives, improve long-term Company performance and create shareholder value.  A fundamental part of risk management is understanding the risks the Company faces and what steps management is taking to manage those risks, but also understanding what level of risk is appropriate for the Company.  The involvement of the full Board in setting the Company’s business strategy and objectives is integral to the Board’s assessment of the Company’s risk and also a determination of what constitutes an appropriate level of risk for the Company.  The full Board conducts an annual risk assessment of the Company’s financial risk, legal/compliance risk and operational/strategic risk and addresses individual risk issues throughout the year as necessary.
 

42



While the Board has the ultimate oversight responsibility for the risk management process, the Board delegates responsibility for certain aspects of risk management to the Audit Committee.  Per its charter, the Audit Committee focuses on key financial risks and related controls and processes and discusses with management the Company’s major financial reporting exposures and the steps management has taken to monitor and control such exposures.
 
The Board believes its leadership structure enhances overall risk oversight.  While the Board requires risk assessments from management, the combination of Board member experience, diversity of perspectives, continuing education and independence of governance processes provide an effective basis for testing, overseeing and supplementing management assessments.
 
Identifying and Evaluating Nominees for Directors
 
The Nominating and Corporate Governance Committee utilizes a variety of methods for identifying and evaluating nominees for director.  The Nominating and Corporate Governance Committee regularly assesses the appropriate size of the Board, and whether any vacancies on the Board are expected due to retirement or otherwise.  In the event that vacancies are anticipated, or otherwise arise, the Nominating and Corporate Governance Committee considers various potential candidates for director.  Candidates may come to the attention of the Nominating and Corporate Governance Committee through current members of the Board, professional search firms, shareholders or other persons.  These candidates are evaluated at regular or special meetings of the Nominating and Corporate Governance Committee, and may be considered at any point during the year.  Shareholder nominations should be addressed to: Novation Companies, Inc., 500 Grand Boulevard, Suite 201B, Kansas City, MO 64106, attention Corporate Secretary.  The Nominating and Corporate Governance Committee will consider properly submitted shareholder nominations for candidates for the Board, following verification of the shareholder status of persons proposing candidates.  If any materials are provided by a shareholder in connection with the nominating of a director candidate, such material will be forwarded to the Nominating and Corporate Governance Committee.  The Nominating and Corporate Governance Committee will also review materials provided by professional search firms or other parties.

The Nominating and Corporate Governance Committee considers candidates for the Board based upon several criteria set forth in the Company’s Corporate Governance Guidelines, including their broad-based business and professional skills and experience, education, accounting and financial expertise, age, reputation, civic and community relationships, concern for the long-term interest of shareholders, personal integrity and judgment, knowledge and experience in the Company’s industry (such as operations, finance, accounting and marketing experience and education) and diversity.  The Nominating and Corporate Governance Committee considers diversity in the broadest sense, thus including factors such as age, gender, race, ethnicity and geographic location, as well as a variety of experience and educational backgrounds when seeking nominees to the Board.  The Nominating and Corporate Governance Committee does not have a formal diversity policy in place.
 
The Nominating and Corporate Governance Committee does not assign specific weights to the criteria and no particular criterion is necessarily applicable to all prospective nominees.  When evaluating nominees, the composition of the entire Board is also taken into account, including the need for a majority of independent directors.  In addition, the assessment of a candidate includes consideration of the number of public boards on which he or she serves because of the time requirements for duties and responsibilities associated with serving on the Board.  The Nominating and Corporate Governance Committee believes that the backgrounds and qualifications of the directors, considered as a group, should provide a significant composite mix of experience, knowledge and abilities that will allow the Board to fulfill its responsibilities.  The Nominating and Corporate Governance Committee assesses the effectiveness of the Corporate Governance Guidelines, including with respect to director nominations and qualifications and achievement of having directors with a broad range of experience and backgrounds, through completion of the annual self-evaluation process.

Involvement in Certain Legal Proceedings

Company director Charles M. Gillman is subject to an SEC administrative order, dated February 14, 2017 (Securities Exchange Act Release No. 80038), relating to alleged violations of Section 13(d) of the Exchange Act and the rules promulgated thereunder, including failing to disclose the members of a stockholder group, and further allegations that he violated Section 16(a) of the Exchange Act and the rules promulgated thereunder, including failing to timely file initial statements of beneficial ownership on Form 3 and changes thereto on Form 4. Without admitting or denying any violations,Mr. Gillman agreed to cease and desist from committing or causing any violations of (i) Section 13(d) of the Exchange Act and Rules 13d-1 and 13d-2 promulgated thereunder and (ii) Section 16(a) of the Exchange Act and Rules 16a-2 and 16a-3 promulgated thereunder, and paid a civil penalty to the SEC in the amount of $30,000.

V.I. Capital Management, LLC (“V.I. Capital”) and Chief Executive Officer and Chairman of the Board David W. Pointer are
subject to a consent order (the “Consent Order”) from the State of Washington Department of Financial Institutions, Securities
Division, dated March 12, 2018 (Order Number S-16-2093-17-CO01), relating to alleged breaches of their fiduciary duty as
investment advisors to their clients, including (i) failure to disclose certain conflict of interest stemming from Mr. Pointer’s
service on the Boards of Directors of CompuMed, Inc. and Solitron Devices, Inc., (ii) pledging V.I. Capital investment
fund assets as collateral for a line of credit for CompuMed, Inc. and failing to disclose such pledge to V.I. Capital’s year-end auditor, and (iii) failure to timely distribute audited financial statements and a final fund audit to investors. As conditions of the Consent Order, V.I. Capital and Mr. Pointer agreed to (i) cease and desist from violating the Securities Act of 1933, (ii) pay a fine of $10,000 and (iii) pay costs of $2,500. Mr. Pointer also agreed that he will not be a principal, officer or owner of an investment

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adviser or broker-dealer for 10 years following the entry of the Consent Order, but he may apply for a securities salesperson or investment adviser representative registration with an acceptable plan of supervision.


SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
 
Section 16(a) of the Exchange Act requires our directors and executive officers, and holders of more than 10% of our common stock, to file with the SEC initial reports of ownership and reports of changes in ownership of common stock and other equity securities of the Company.  Such persons are required by SEC regulations to furnish us with copies of all Section 16(a) forms they file.  Based solely upon a review of the copies of the forms furnished to us and written representations made by our directors and officers, we believe that our directors, officers and holders of more than 10% of our common stock complied with all applicable filing requirements during fiscal year 2017, except that Messrs. Eberwein and Igdaloff each filed a Form 4 on
December 18, 2017, reporting a transaction that occurred on December 13, 2017, and Mr. Rector filed a Form 4 on August 2,
2017, reporting a transaction that occurred on July 27, 2017.

Item 11. Executive Compensation

DIRECTOR COMPENSATION

The following table presents a summary of the compensation earned by each director who served on the Board during the fiscal year ended December 31, 2017, other than our former Executive Chairman Mr. Eberwein, whose compensation is described in the Executive Compensation section below:
Name and Principal Position
Fees earned or paid in cash ($)
Stock
Awards ($) (1)

Total ($)
Barry A. Igdaloff
$
21,411

$
25,000

$
46,411

Howard M. Amster
8,921

25,000

33,921

Charles M. Gillman
8,921

25,000

33,921

Robert G. Pearse
11,598

25,000

36,598

(1) Represents the aggregate grant date fair value computed in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 718.

On August 23, 2017, the Board approved base compensation for each of the Company’s non-employee directors, Barry A. Igdaloff, Howard M. Amster, Charles M. Gillman and Robert G. Pearse, in an amount of $50,000 per annum, including (i) $25,000 in restricted stock awards, vesting on the first anniversary of the grant date, and (ii) $25,000 in cash, payable on a quarterly basis. The Board approved additional compensation for the chairmen of the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee and the Lead Independent Director in the amounts of $10,000, $7,500, $5,000 and $20,000, respectively, in cash, payable on a quarterly basis. In order to satisfy the foregoing compensation, on the same date, the Compensation Committee granted to each of the non-employee directors a $25,000 restricted stock award, which vests on the first anniversary of the grant date, pursuant to the terms and conditions of the 2015 Incentive Plan and each director’s respective award agreement, as a component of such director’s base compensation.

On December 12, 2017, the Compensation Committee approved one-time additional compensation of $25,000 in cash and 357,143 shares of restricted stock for Mr. Igdaloff in recognition of his considerable time and effort in connection with the Company’s successful emergence from bankruptcy. These restricted stock awards vest one year from the grant date.

EXECUTIVE COMPENSATION

Our named executive officers during 2017 (each a “Named Executive Officer”) were (i) Carolyn K. Campbell, our Chief Financial Officer, (ii) Richard M. Rector, President of HCS, (iii) Jeffrey E. Eberwein, our former Executive Chairman and (iv) Rodney E. Schwatken, our former Chief Executive Officer, Chief Financial Officer and Treasurer.

Summary Compensation Table

The following table sets forth the compensation of our Named Executive Officers for the periods indicated.

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Name and Principal Position
Year
Salary
Bonus
Stock
Awards (1)
All Other Compensation
Total
Carolyn K. Campbell (2)
2017
$
43,934

$

$
15,750

$

$
59,684

Chief Financial Officer
 
 
 
 
 
 
Richard M. Rector (3)
2017
101,923