WSTF Westaff (MM)

ITEM 1A.    RISK FACTORS.

Factors Affecting Future Operating Results

        This Annual Report on Form 10-K contains forward-looking statements concerning our future programs, products, expenses, revenue, liquidity and cash needs as well as our plans and strategies. These forward-looking statements are based on current expectations and we assume no obligation to update this information, except as required by applicable laws and regulations. Numerous factors could cause actual results to differ significantly from the results described in these forward-looking statements, including the following risk factors.

        Investing in our securities involves risk. The following risk factors, issues and uncertainties should be considered when evaluating our future prospects. In particular, please consider these risk factors when reading "forward-looking" statements which appear throughout this report. Forward-looking statements relate to our expectations for future events and time periods. Generally, words such as "expect," "intend," "anticipate" and similar expressions identify forward-looking statements. Each of these forward-looking statements involves risks and uncertainties, and future events and circumstances could differ significantly from those anticipated in the forward-looking statements. Any one of the following risks could harm our operating results or financial condition and could result in a significant decline in value of an investment in us. Further, additional risks and uncertainties that have not yet been identified or which we currently believe are immaterial may also harm our operating results and financial condition.

         We have significant working capital requirements and are heavily dependent upon our ability to borrow money to meet these working capital requirements.

        We require significant amounts of working capital to operate our business and to pay expenses relating to employment of temporary employees. Temporary personnel are generally paid on a weekly basis while payments from customers are generally received 30 to 60 days after billing. As a result, we must maintain sufficient cash availability to pay temporary personnel prior to receiving payment from customers. Any lack of access to liquid working capital would have an immediate, material, and adverse impact on our business.

        We finance our operations primarily through borrowings under revolving credit facilities with GE Capital and also through cash generated by our operating activities. As of November 3, 2007, our total borrowing capacity was $19.1 million consisting of $9.3 million for the domestic operations, $5.8 million for Australia and $4.0 million for the United Kingdom.

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        The amount we are entitled to borrow under our revolving credit facilities is calculated daily and is dependent on eligible trade accounts receivable generated from operations, which are affected by financial, business, economic and other factors, as well as by the daily timing of cash collections and cash outflows. If we experience a significant and sustained drop in operating profits, or if there are unanticipated reductions in cash inflows or increases in cash outlays, we may be subject to cash shortfalls. If such a shortfall were to occur for even a brief period of time, it may have a significant adverse effect on our business. Furthermore, our receivables may not be adequate to allow for borrowings for other corporate purposes, such as capital expenditures or growth opportunities, and we would be less able to react to changes in the market or industry conditions.

        We typically experience significant seasonal and other fluctuations in our borrowings and borrowing availability, particularly in the US, and have, in the past, been required to aggressively manage our cash to ensure adequate funds to meet working capital requirements. Such steps included working to improve collections and adjusting the timing of cash expenditures, reducing operating expenses where feasible and working to generate cash from a variety of other sources.

        We have historically experienced periods of negative cash flow from operations and investment activities, especially during seasonal peaks in revenue experienced in the third and fourth fiscal quarters of the year. In addition, we are required to pledge amounts to secure letters of credit that collateralize certain workers' compensation obligations, and these amounts may increase in future periods. Any such increase in pledged amounts or sustained negative cash flows would decrease amounts available for working capital purposes and could have an adverse effect on our liquidity and financial condition.

         We are currently in default on our existing credit facilities and failure to cure the default or obtain other financing severely impacts our ability to operate.

        Our credit facilities with GE Capital as amended, required a minimum adjusted earnings before interest, taxes, depreciation and amortization ("EBITDA") of $9.5 million for the trailing 13 periods and a minimum fixed charge ratio of 1.25. We failed to meet the EBITDA requirement at the end of our Fiscal Quarter ended July 7, 2007 and failed the Minimum Fixed Charge Coverage Ratio for the trailing 13 fiscal periods ended August 4, 2007 and September 1, 2007.

        We entered into a 120 day Forbearance Agreement, Limited Waiver and Consent of Guarantors ("Forbearance Agreement") with GE Capital, on October 18, 2007, which required us to maintain a minimum Borrowing Availability no less than $1.0 million for more than two consecutive business days for the first 60 days from the date of the Forbearance Agreement. Following the initial 60 day period and continuing until February 15, 2008 ("Forbearance Period"), the Company is required to maintain a ten business day rolling average borrowing availability of at least $8.0 million, which is measured every seven days. The Forbearance Agreement also waived both the Minimum Fixed Charge Coverage Ratio covenant during the Forbearance Period and the EBITDA requirement, however, the Company is required to meet a minimum EBITDA of $1.0 million for fiscal 2007 as defined in the GE Capital Credit Agreement.

        At fiscal year end 2007, we met the initial borrowing availability test required during the initial 60 days. We achieved the minimum EBITDA $1.0 million requirement under the Forbearance Agreement. Our borrowing availability as calculated under the agreement fluctuates based on a number of business conditions and factors. We failed to meet the $8.0 million minimum availability requirement

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contained in the Forbearance Agreement for four testing periods. The dates and the amounts by which we failed to achieve the requirement are noted below:

        We have had preliminary discussions with GE Capital regarding obtaining a waiver from our forbearance events of default (availability test requirements as previously noted), as well as in pursuing alternative financing arrangements, upon the expiration of our Forbearance Agreement on February 15, 2008. Although no written communications have been exchanged by either party in this matter, the extension of such forbearance is subject to negotiation, which includes the possibility of additional fees and covenant requirements. The specific terms of such extension would be subject to negotiation with GE Capital. At the date of termination of the Forbearance Agreement, and assuming no extension had been agreed, GE Capital could proceed to exercise any and all of their respective rights and default related remedies, as specified under the Credit Agreement. Such remedies include the right to cancel our standby letters of credit that secure our worker compensation obligations, and limit our ability to continue borrowing funds pursuant to the credit facility. In addition, GE Capital can require immediate repayment of all outstanding amounts borrowed under the revolving credit line.

        We have also been engaged in active negotiations with another large financial institution (ABL lender) to refinance the existing multi-currency agreement with similar limits and collateralization. We entered into a term sheet in late 2007 with this ABL lender and have made significant progress in working through loan documents. We have agreed in principle to the major terms of the agreement, and anticipate closing such arrangement in February of 2008.

         The staffing industry is highly competitive with limited barriers to entry which could limit our ability to maintain or increase market share.

        The staffing industry is highly competitive with limited barriers to entry and continues to undergo consolidation. We compete in regional and local markets with large full service agencies, specialized temporary and permanent placement services agencies and small local companies. While some competitors are smaller than us, they may enjoy an advantage in discrete geographic markets because of a stronger local presence. Other competitors have greater marketing, financial and other resources than us that, among other things, could enable them to attempt to maintain or increase their market share by reducing prices. Furthermore, in past years there has been an increase in the number of customers consolidating their staffing services purchases with a single provider or with a small number of providers. The trend to consolidate staffing services purchases has in some cases made it more difficult for us to obtain or retain business.

         Price competition in the staffing industry continues to be intense, and pricing pressures from both competitors and customers could adversely impact our financial decisions.

        We expect the level of competition to remain high in the future, and competitive pricing pressures will continue to make it difficult for us to raise our prices to immediately and fully offset increased costs of doing business, including increased labor costs, costs for workers' compensation and, domestically, state unemployment insurance. If we are not able to effectively compete in our targeted markets, our operating margins and other financial results will be harmed and the price of our securities could decline. We also face the risk that our current or prospective customers may decide to provide services internally.

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         We have had significant turnover in our management team and further loss of any of our key personnel could harm our business.

        On May 1, 2007, our former Chief Executive Officer resigned from the Company and was replaced by Michael T. Willis. On June 29, 2007, our Chief Financial Officer resigned from the company. We hired a new Chief Financial Officer, Dawn M. Jaffray, effective August 7, 2007. Our VP of Information Services, Eric Person, resigned on January 25, 2008. We currently have an interim Chief Information Officer with industry experience and are searching for a full time replacement.

        Our future financial performance is significantly impacted by our ability to attract, motivate and retain key management personnel and other members of the senior management team. Competition for qualified management personnel is intense and in the event that we experience turnover in senior management positions, we cannot assure that we will be able to recruit suitable replacements on a timely basis. We must also successfully integrate all new management and other key positions within our organization to achieve our operating objectives. Even if we are successful, turnover in key management positions could temporarily harm our financial performance and results of operations until the new management becomes familiar with our business.

We have hired key executives to increase our business growth for fiscal 2008 and beyond.

        We made significant changes to our field structure in fiscal 2007 and hired several new key executives late in the fiscal year who have been brought on to grow new business markets for the Company. Our failure to implement these new strategies could impede our growth and result in significant added costs.

         Our principal stockholder, together with its affiliates, controls a significant amount of our outstanding common stock thus allowing them to exert significant influence on our management and affairs.

        As of January 25, 2008, our principal stockholder, DelStaff LLC ("DelStaff"), together with its affiliates controls approximately 49.6% of the total outstanding shares of common stock. The members of DelStaff are H.I.G. Staffing, 2007, Ltd., Alarian Associates, Inc. and Michael T. Willis. As our principal stockholder, DelStaff and its affiliates have the ability to significantly influence all matters submitted to our stockholders for approval, including the election of directors, and to exert significant influence over management and affairs. On April 30, 2007, we entered into a Governance Agreement with DelStaff, Mr. Willis and W. Robert Stover. Pursuant to the terms of the Governance Agreement, on May 9, 2007, we expanded the size of our Board of Directors from five to nine directors and appointed the following DelStaff nominees to the Board: Michael T. Willis, John R. Black, Michael R. Phillips, Gerald E. Wedren and John G. Ball. DelStaff also has the ability to strongly influence any merger, consolidation, sale of substantially all of our assets or other strategic decisions affecting us or the market value of the stock. This concentration of stock and voting power could be used by DelStaff to delay or prevent an acquisition of Westaff or other strategic action or result in strategic decisions that could negatively impact the value and liquidity of our outstanding stock.

         The amount of collateral that we are required to maintain to support our workers' compensation obligations could increase, reducing the amount of capital that we have available to support and grow our field operations.

        We are contractually obligated to collateralize our workers' compensation obligations under our workers' compensation program through irrevocable letters of credit, surety bonds or cash. As of November 3, 2007 our aggregate collateral requirements under these contracts have been secured through $28.2 million of letters of credit. Further, our workers' compensation program expires November 1, 2008, and as part of the renewal, could be subject to an increase in collateral. These collateral requirements are significant and place pressure on our liquidity and working capital capacity.

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We believe that our current sources of liquidity are adequate to satisfy our immediate needs for these obligations; however, our available sources of capital are limited. Depending on future changes in collateral requirements, we could be required to seek additional sources of capital in the future, which may not be available on commercially reasonable terms.

         Our reserves for workers' compensation claims may be inadequate to cover our ultimate liability, and we may incur additional charges if the actual amounts exceed the reserved amounts.

        We maintain reserves to cover our estimated liabilities for workers' compensation claims based upon actuarial estimates of the future cost of claims and related expenses which have been reported but not settled, and that have been incurred but not yet reported. The determination of these reserves is based on a number of factors, including current and historical claims activity, medical cost trends and developments in existing claims. Reserves do not represent an exact calculation of liability and are affected by both internal and external events, such as adverse development on existing claims, changes in medical costs, claims handling procedures, administrative costs, inflation, legal trends and legislative changes. Reserves are adjusted as necessary to reflect new claims and existing claims development, and such adjustments are reflected in the results of the periods in which the reserves are adjusted. While we believe our judgments and estimates are adequate, if our reserves are insufficient to cover our actual losses, an adjustment could be charged to expense that may be material to our earnings.

         Workers' compensation costs for temporary employees may continue to rise and reduce margins and require more liquidity.

        In the United States, we are responsible for and pay workers' compensation costs for our regular and temporary employees. In recent years, these costs have risen substantially as a result of increased claims, general economic conditions, increases in healthcare costs and governmental regulations. In fiscal 2007, the increase in the volume of claims has fallen despite an increase in our domestic revenue, yet the increases in cost per claim have continued. Under our workers' compensation insurance program, we maintain "per occurrence" insurance, which only covers claims for a particular event above a $500,000 deductible. This deductible has been increased for our policy year ending November 1, 2008 to $750,000. Our workers' compensation insurance policy expires November 1, 2008 and we cannot guarantee that we will be able to successfully renew such policy. Further, there are covenants associated with the continuation of the policy and there can be no guarantee that we will continue to meet those covenants going forward. Should our workers' compensation premium costs continue to increase in the future, there can be no assurance that we will be able to increase the fees charged to our customers to keep pace with increased costs or if we were unable to obtain insurance on reasonable terms or forced to significantly increase our deductible per claim, our results of operations, financial condition and liquidity could be adversely affected.

         Any significant economic downturn could result in our customers using fewer staffing services, which could materially adversely affect our business.

        Demand for staffing services is significantly affected by the general level of economic activity. As economic activity slows, many customers reduce their utilization of temporary employees before undertaking layoffs of their regular full-time employees. Further, demand for permanent placement services also slows as the labor pool directly available to our customer's increases, making it easier for them to identify new employees directly. Typically, we may experience increased pricing pressures from other staffing companies during periods of economic downturn, which could have a material adverse effect on our financial condition. Additionally, in geographic areas where we derive a significant amount of business, a regional or localized economic downturn could adversely affect our operating results and financial position.

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         We assume the obligation to make wage, tax, and regulatory payments to our temporary employees and are then exposed to accounts receivable risks from our customers.

        We generally assume responsibility for and manage the risks associated with our payroll obligations, including liability for payment of salaries and wages, payroll taxes as well as group health insurance. These obligations are fixed and become a liability of ours, whether or not the associated client where these employees have been assigned makes payments required by our service agreement, which exposes us to credit risks. We attempt to mitigate this risk by billing on a frequent basis, which typically occurs daily or weekly. In addition, we establish an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required and timely payments. Further, we carefully monitor the timeliness of our customers' payments and impose strict credit standards. Finally, the majority of our accounts receivable is used to secure our revolving credit facilities, which we rely on for liquidity. If we fail to adequately manage our credit risks associated with accounts receivable, our financial position could be adversely impacted.

         We derive a significant portion of our revenue from franchise agent operations.

        Franchise agent operations comprise a significant portion of our revenue. Franchisees represented 26.7% of gross receipts in fiscal 2007. In addition, our ten largest franchise agents accounted for 17.7% of our revenue. There can be no assurances that we will be able to attract new franchisees or that we will be able to retain our existing franchisees. The loss of one or more of our franchise agents and any associated loss of customers and sales could have a material adverse effect on our results of operations.

         We are subject to business risks associated with international operations and fluctuating exchange rates.

        We presently have operations in the United Kingdom, Australia and New Zealand, which comprised 25.3% of our revenue during fiscal 2007. Operations in foreign markets are inherently subject to certain risks, including in particular:

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differences in cultures and business practices;



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overlapping or differing tax laws and regulations;



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economic and political uncertainties;



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differences in accounting and reporting requirements;



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changing, complex or ambiguous foreign laws and regulations, particularly as they relate to employment; and



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litigation and claims.

        All of our sales outside of the United States are denominated in local currencies and, accordingly, we are subject to risks associated with fluctuations in exchange rates, which could cause a reduction in our profits. There can be no assurance that any of these factors will not have a material adverse effect on our business, results of operations, cash flows or financial condition.

         Our success is impacted by our ability to attract and retain qualified temporary and permanent candidates.

        We compete with other staffing services to meet our customers' needs, and we must continuously attract reliable candidates to meet the staffing requirements of our customers. Consequently, we must continuously evaluate and upgrade our base of available qualified personnel to keep pace with changing customer needs and emerging technologies. Furthermore, a substantial number of our temporary employees during any given year will terminate their employment with us and accept regular staff employment with our customers. Competition for individuals with proven skills remains intense, and

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demand for these individuals is expected to remain strong for the foreseeable future. There can be no assurance that qualified candidates will continue to be available to us in sufficient numbers and on acceptable terms to us. The failure to identify, recruit, train and place candidates as well as retain qualified temporary employees over a long period of time could materially adversely affect our business.

         Our service agreements may be terminated on short notice, leaving us vulnerable to loss of a significant amount of customers in a short period of time.

        Our service agreements are generally cancellable with little or no notice by the customer to us. As a result, our customers can terminate their agreement with us at any time, making us particularly vulnerable to a significant decrease in revenue within a short period of time that could be difficult to quickly replace.

         The cost of unemployment insurance for temporary employees may rise and reduce our margins.

        In the United States, we are responsible for and pay unemployment insurance premiums for our temporary and regular employees. At times, these costs have risen as a result of increased claims, general economic conditions and government regulations. Should these costs continue to increase, there can be no assurance that we will be able to increase the fees charged to our customers in the future to keep pace with the increased costs, and if we do not, our results of operations and liquidity could be adversely affected.

         Our information technology systems are critical to the operations of our business.

        Our information management systems are essential for data exchange and operational communications with branches spread across large geographical distances. We have replaced key component hardware and software including backup systems within the past twelve months.

        On November 12, 2007 we implemented a new accounts receivable billing and temporary payroll system. The new system receives information from our custom built front office system. We experienced technical issues after the conversion that were not detected during the testing phases. These issues affected both the payroll and billing systems. We believe that we have identified the significant issues and are working to resolve those. These issues were disruptive to our business and could affect customer and employee relations. Additionally, these issues required significant amount of management time that impacted our ability to sell new services during the first quarter of fiscal 2008. Continued interruption, impairment or loss of data integrity or malfunction of these systems could severely impact our business, especially our ability to timely and accurately pay employees and bill customers.

         Our business is subject to extensive government regulation, which may restrict the types of employment services that we are permitted to offer or result in additional tax or other costs that adversely affect our revenues and earnings.

        We are in the business of employing people and placing them in the workplace of other businesses on either a temporary or permanent basis. As a result, we are subject to extensive laws and regulations relating to employment. Changes in laws or government regulations may result in prohibition or restriction of certain types of employment services we are permitted to offer or the imposition of new or additional benefit, licensing or tax requirements that could reduce our revenues and earnings. There can be no assurance that we will be able to increase the fees charged to our customers in a timely manner and in a sufficient amount to cover increased costs as a result of any changes in laws or government regulations. Any future changes in laws or government regulations may make it more difficult or expensive for us to provide staffing services and could have a material adverse effect on our business, financial condition or results of operations.

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         We may be exposed to employment-related claims and costs that could materially adversely affect our business.

        The risks related to engaging in our business include but are not limited to:

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claims by our placed personnel of discrimination and harassment directed at them, including claims arising from the actions of our customers;



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workers' compensation claims and other similar claims;



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violations of wage and hour laws and requirements;



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claims of misconduct, including criminal activity or negligence on the part of our placed personnel;



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claims by our customers relating to actions by our placed personnel, including property damage and personal injury, misuse of proprietary information and misappropriation of assets or other similar claims; and



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immigration related claims.

        In addition, some or all of these claims may give rise to litigation, which could be time-consuming to our management team, and therefore, could have a negative effect on our business, financial conditions and results of operations. In some instances, we have agreed to indemnify our customers against some or all of these types of liabilities. We have policies and guidelines in place to help reduce our exposure to these risks and have purchased insurance policies against certain risks in amounts that we currently believe to be adequate. However, there can be no assurance that our insurance will be sufficient in amount or scope to cover these types of liabilities or that we will be able to secure insurance coverage for such risks on affordable terms. Furthermore, there can be no assurance that we will not experience these issues in the future or that they could have a material adverse effect on our business.

         The market for our stock may be limited, and the stock price may continue to be extremely volatile.

        The average daily trading volume for our common stock on the NASDAQ Global Market was approximately 25,000 shares during fiscal 2007. Accordingly, the market price of our common stock is subject to significant fluctuations that have been, and may continue to be, exaggerated because an active trading market has not developed for our common stock. We believe that the price of our common stock has also been negatively affected by the fact that our common stock is thinly traded and also due to the absence of analyst coverage. The lack of analyst reports about our stock may make it difficult for potential investors to make decisions about whether to purchase our stock and may make it less likely that investors will purchase the stock, thus further depressing the stock price. These negative factors may make it difficult for stockholders to sell our common stock, which may result in losses for investors.

         The compliance costs associated with Section 404 of the Sarbanes-Oxley Act regarding internal control over financial reporting could be substantial, while failure to achieve and maintain compliance could have an adverse effect on our stock price.

        Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and current SEC regulations and proposed rules, beginning with our Annual Report for the fiscal year ended November 1, 2008, we expect to be required to furnish a report by our management on our internal control over financial reporting. Further, we expect that the SEC will pass its proposal to delay the auditors' attestation so that our external auditors will be required to audit our internal control over financial reporting report and include their attestation on that report in our annual report on Form 10-K starting from our annual report for the 2010 fiscal year. The process of fully documenting and testing our internal control

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procedures in order to satisfy these requirements will result in increased general and administrative expenses and may shift management time and attention from profit-generating activities to compliance activities. Furthermore, during the course of our internal control testing, we may identify deficiencies which we may not be able to remediate in time to meet the reporting deadline under Section 404. Failure to achieve and maintain an effective internal control environment or complete our Section 404 certifications could have a material adverse effect on our stock price.

         We are involved in an action taken by the California Employment Development Department.

        During the fourth quarter of fiscal 2005, we were notified by the California Employment Development Department, or EDD, that our domestic operating subsidiaries unemployment tax rates would be increased retroactively for both calendar years 2005 and 2004, which would result in additional unemployment taxes of approximately $0.9 million together with interest at applicable statutory rates. We have timely appealed the ruling by the EDD and are working with our outside counsel to resolve this matter. Although we believe that we have properly calculated our unemployment insurance tax and are in compliance with all applicable laws and regulations, there can be no assurances this will be settled in our favor.

         We have significant amounts of assets on our balance sheet for which their realization is dependent on our future profitability.

        As of November 3, 2007 we have deferred tax assets of $21.8 million and goodwill and intangible assets of $16.3 million. Under Generally Accepted Accounting Principles, we are required to evaluate the realizability of the deferred tax assets based on our ability to generate future taxable income. Similiarly, we are required to periodically compare the carrying value of our goodwill and intangible assets to their estimated fair value to support the current recorded amounts. The estimated fair value will be influenced by our future profitability. If we are unable to return to our historical levels of profitability, we may need to write off a portion or all of these assets which would result in a reduction of our assets, stockholders equity and adversely affect our operating results.

         We are a defendant in a variety of litigation and other actions from time to time, which may have a material adverse effect on our business, financial condition and results of operations.

        We are regularly involved in a variety of litigation arising out of our business and, in recent years, have paid significant amounts as a result of adverse arbitration awards. We do not have insurance for some of these claims, and there can be no assurance that the insurance coverage we have will cover all claims that may be asserted against us. Should the ultimate judgments or settlements not be covered by insurance or exceed our insurance coverage, they could have a material adverse effect on our results of operations, financial position and cash flows. There can also be no assurance that we will be able to obtain appropriate and sufficient types or levels of insurance in the future or that adequate replacement policies will be available on acceptable terms, if at all.

         Improper disclosure of employee and customer data could result in liability and harm to our reputation.

        Our business involves the use, storage and transmission of information about our employees and their customers. It is possible that our security controls over personal data and other practices we and our third party service providers follow may not prevent the improper access to or disclosure of personally identifiable information. Such disclosure could harm our reputation and subject us to liability under our contracts and laws that protect personal data, resulting in increased costs or loss of revenue. Further, data privacy is subject to frequently changing rules and regulations. Our failure to adhere to or successfully implement processes in response to changing regulatory requirements in this area could result in legal liability or impairment to our reputation in the marketplace.

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