Item 1A. Risk Factors
The following description of risk factors includes material changes to, and supersedes, the description of risk factors previously disclosed in Part 1, Item 1A of our Annual Report on Form 10-K for the year ending December 31, 2020.
We may not receive the amount owed us under the secured promissory note from S&L.
The S&L Note, which had an outstanding principal amount of $3.3 million as of December 31, 2020, will mature and the entire principal amount will be payable in March 2023. During 2020, we recorded an impairment loss of $833,000 on the S&L Note as a result of concluding, based on current information and events, including the impact of the novel coronavirus (“COVID-19”) on S&L’s business and its customers, that we did not believe we would be able to collect the entire amount due under the S&L Note. S&L’s ability to make payments to us under the S&L Note may continue to be adversely impacted by the current pandemic health event resulting from COVID-19 as S&L’s operations may continue to be adversely impacted by disruptions to the supply chain and distribution channels for its products caused by this pandemic. Consequently, we may have to record additional impairment charges with respect to the S&L Note. There is no guarantee that S&L will pay us the amounts owed under the S&L Note or that, in the event of default by S&L, the collateral securing the S&L Note will be sufficient to pay the S&L Note in full.
Our business may be adversely impacted as a result of the pandemic health event resulting from COVID-19.
The pandemic health event resulting from COVID-19 has adversely impacted, and may continue to adversely impact, economic activity nationally and globally. These economic and market conditions and other effects resulting from COVID-19 may adversely affect us. At this point, the extent to which COVID-19 may impact us is uncertain. S&L’s ability to make payments to us under the S&L Note may continue to be adversely impacted by the current pandemic health event resulting from COVID-19 as S&L’s operations may continue to be adversely impacted by disruptions to the supply chain and distribution channels for its products caused by this pandemic. Consequently, we may have to record additional impairment charges with respect to the S&L Note.
We will also monitor the impact of this pandemic on our investment in HC Realty, but we are not currently anticipating a significant impact as HC Realty holds properties that are leased entirely to the United States Government for occupancy by federal agencies. Many of these federal agencies are deemed essential and continued operations amidst the various federal, state, and local restrictions aimed at slowing the spread of COVID-19. It is possible, however, that a resurgence in COVID-19 cases resulting in tighter restrictions may have the effect of heightening adverse impacts to HC Realty’s operations.
We will also monitor the impact of the pandemic on participants in real estate transaction and the demand for NCTIC and Omega’s products and services.
An “ownership change” could limit the use of our net operating loss carryforwards and our potential to derive a benefit from our net operating loss carryforwards.
If an “ownership change” occurs pursuant to applicable statutory regulations, we are potentially subject to limitations on the use of our net operating loss carryforwards which in turn could adversely impact our potential to derive a benefit from our net operating loss carryforwards. While we have entered into a rights agreement designed to preserve and protect our net operating loss carryforwards, there is no guarantee that the rights agreement will prevent us from experiencing an ownership change and, therefore, having a limitation on our ability to use our net operating loss carryforwards. In general, an “ownership change” would occur if there is a cumulative change in the ownership of our common stock of more than 50% by one or more “5% shareholders” during a three-year test period.
Failure to successfully identify, acquire and, to the extent applicable, operate non-furniture related assets could cause our stock price to decline.
We continue evaluating alternatives for using remaining cash proceeds from the Asset Sale and Rights Offering to acquire non-furniture related assets. Since the Asset Sale, we have completed the Acquisition of NCTIC and NCTG and the equity interest we acquired in HC Realty. We may not be able to acquire other profitable assets with the remaining cash proceeds of the Asset Sale and Rights Offering. In addition, any assets that we do acquire, including the Acquisition and our equity interest in HC Realty, may not be profitable. If we are not successful in identifying, acquiring and, to the extent applicable, operating non-furniture related assets, our stock price may decline.
We have no operating history in the NCTIC’s title insurance and Omega’s title agency businesses, and therefore, with respect to certain assets, we will be subject to the risks inherent in establishing a new line of business.
We have had no operating history in the title insurance and title agency lines of business for which NCTIC and Omega operate. Accordingly, our future success may in part be subject to the risks, expenses, problems and delays inherent in establishing a new line of business and the ultimate success of such new business cannot be assured. In addition, prior to March 2019, our management did not have prior experience relating to an investment in a real estate investment trust (“REIT”) such as HC Realty and the ultimate success of our investment in HC Realty cannot be assured.
Resources may be expended in researching potential acquisitions that might not be consummated.
The investigation of additional non-furniture company assets to acquire and the negotiation, drafting and execution of relevant agreements and other documents will require substantial management time and attention in addition to potentially incurring legal and other professional expenses. If a decision is made not to complete a specific acquisition, the costs incurred up to that point for the proposed transaction likely would not be recoverable. As of June 30, 2021 and December 31, 2020, we had incurred no such related expenses. Furthermore, even if an agreement is reached relating to a specific acquisition, we may fail to consummate the acquisition for any number of reasons including those beyond our control.
We may be required to register under the Investment Company Act of 1940.
Under Section 3(a)(l) of the 1940 Act, an issuer is deemed to be an investment company if it is engaged in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire “investment securities” having a value exceeding 40% of the value of the issuer’s total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis. The 1940 Act defines “investment securities” broadly to include virtually all securities except U.S. government securities and securities issued by majority-owned subsidiaries that are not themselves regulated or exempt investment companies. Consequently, the A&R Note (while it was outstanding) and S&L Note, as well as the securities of HC Realty we hold, may be considered investment securities and we may fall within the scope of Section 3(a)(1)(C) of the 1940 Act.
A company that falls within the scope of Section 3(a)(1)(C) of the 1940 Act can avoid being regulated as an investment company if it can rely on certain of the exclusions or exemptions under the 1940 Act. One such exclusion is Rule 3a-2 under the 1940 Act, which temporarily relieves certain issuers that are in transition to a non-investment company business from regulation under the1940 Act (a “transient investment company”). The rule provides a one-year safe harbor for a company to comply with another exemption or exclusion under the 1940 Act provided that the company has a bona fide intent to be primarily engaged in a business other than that of investing, reinvesting, owning, holding or trading in securities. The one-year grace period started on the date of the Asset Sale, which was March 2, 2018, and ended on March 2, 2019. We did not acquire sufficient assets within one year from closing the Asset Sale as contemplated by Rule 3a-2. There is no assurance that we will not be deemed subject to the 1940 Act and be required to register as an investment company.
While in transient investment company status, we actively pursued alternatives for using cash proceeds from the Asset Sale for the acquisition of non-furniture related assets and acquired an equity interest in HC Realty on March 19, 2019. On April 3, 2020, we used $1.0 million of our cash to purchase an additional 100,000 shares of HC Realty Series B Stock. On April 29, 2020, we used an additional $2.5 million of our cash to purchase an additional 250,000 shares of HC Realty Series B Stock. On June 29, 2020, we used $4.75 million of the cash proceeds from the Rights Offering to purchase an additional 475,000 shares of HG Realty Series B Stock. As a result of these purchases, we now own approximately 37.0% of the as-converted equity interest in HC Realty. We believe that these additional purchases allow us to rely on the exemption from investment company registration set forth in Rule 3a-1 of the 1940 Act because we own (i) at least 25% of the HC Realty Common Stock on an as-converted basis, resulting in us being presumed to control HC Realty within the meaning of Section 2(a)(9) of the 1940 Act and (ii) a sufficient number of shares of HC Realty Series B Stock so that we primarily control HC Realty within the meaning of Rule 3(a)-1 of the 1940 Act.
The Company has not sought or obtained an exemptive order, no-action letter or any other assurances from the SEC or its staff regarding the Company’s ability to rely on Rule 3a-2 or Rule 3a-1 of the 1940 Act, nor has the SEC or its staff provided any such order, no-action letter or other assurances. If we are required to register under the 1940 Act, compliance with these additional regulatory burdens would significantly increase our operating expenses. Registered investment companies are subject to extensive, restrictive and potentially adverse regulation relating to, among other things, operating methods, management, capital structure, dividends and transactions with affiliates.
Other risks specific to our investment in HC Realty
Our investment in HC Realty may lose value.
In connection with using cash proceeds from the Asset Sale to acquire non-furniture related assets, we acquired an equity interest in HC Realty on March 19, 2019 by purchasing HC Common Stock and HC Series B Stock. We acquired additional HC Series B Stock on April 3, April 29, and June 29, 2020. As a result of these stock purchases, we currently own 36.4% of the as-converted equity interest of HC Realty. There is no guarantee that HC Realty will be successful implementing its business strategy for the acquisition, management and disposition of GSA properties and as a result our HC Common Stock and HC Series B Stock may lose value.
The value of our equity investment in HC Realty would be adversely affected if HC Realty failed to qualify as a REIT.
HC Realty has elected to be treated as a REIT for U.S. federal income tax purposes. Its continued qualification as a REIT depends on its satisfaction of certain asset, income, organizational, distribution and stockholder ownership requirements on a continuing basis. Its ability to satisfy some of the asset tests depends upon the fair market values of its assets, some of which are not able to be precisely determined and for which HC Realty has indicated it will not obtain independent appraisals. If HC Realty fails to qualify as a REIT in any taxable year, and certain statutory relief provisions are not available, HC Realty would be subject to U.S. federal income tax on its taxable income at regular corporate rates and distributions to stockholders would not be deductible by it in computing its taxable income. Any such corporate tax liability could be substantial and would reduce the amount of cash available for distribution. Unless entitled to relief under certain Internal Revenue Code provisions, HC Realty also would be disqualified from taxation as a REIT for the four taxable years following the year during which HC Realty ceased to qualify as a REIT. In addition, if HC Realty fails to qualify as a REIT, HC Realty will no longer be required to make distributions. As a result of all these factors, HC Realty’s failure to qualify as a REIT could impair its ability to expand business and raise capital and could adversely affect the value of our HC Common Stock and HC Series B Stock.
Other risks specific to the Acquisition of the Title Insurance Businesses
Conditions in the real estate market generally impact the demand for a substantial portion of the Company’s title insurance subsidiaries’ products and services and NCTIC’s claims experience.
Demand for a substantial portion of the Company’s insurance subsidiaries’ products and services generally decreases as the number of real estate transactions in which its products and services are purchased decreases. The number of real estate transactions in which the insurance subsidiaries’ products and services are purchased decreases in the following situations, among others:
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When mortgage interest rates are high or rising;
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When the availability of credit, including commercial and residential mortgage funding, is limited; and
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When real estate affordability is declining.
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These circumstances, particularly when combined with declining real estate values and the increase in foreclosures that often results therefrom, also tend to adversely impact NCTIC’s title claims experience.
Unfavorable economic conditions may adversely affect NCTIC and Omega.
Historically, uncertainty and negative trends in general economic conditions in the United States and abroad, including significant tightening of credit markets and a general decline in the value of real property, have created a difficult operating environment for the NCTIC and Omega’s core title and settlement businesses. Uncertainty and a deterioration in economic conditions in connection with the coronavirus pandemic adversely affected the NCTIC and Omega early in the pandemic. These conditions also tend to negatively impact the amount of funds NCTIC receives from third parties to be held in trust pending the closing of commercial and residential real estate transactions. During periods of unfavorable economic conditions, the return on these funds deposited with third party financial institutions, tends to decline. In addition, title agencies, such as Omega, may have been negatively impacted by these conditions, as well as other securities in NCTIC has in its investment portfolio, which also may be negatively impacted by these conditions. Depending upon the ultimate severity and duration of any economic downturn, the resulting effects on NCTIC and Omega could be materially adverse, including a significant reduction in revenues, earnings and cash flows, deterioration in the value of or return on its investments and increased credit risk from customers and others with obligations to NCITC and Omega.
Changes in NCTIC’s relationships with large mortgage lenders or government–sponsored enterprises could adversely affect the Company.
Large mortgage lenders and government-sponsored enterprises, because of their significant role in the mortgage process, have significant influence over NCTIC and other service providers. Changes in NCTIC’s relationship with any of these lenders or government-sponsored enterprises, the loss of all or a portion of the business NCTIC derives from these parties, any refusal of these parties to accept NCTIC’s products and services, the modification of the government-sponsored enterprises’ requirement for title insurance in connection with mortgages they purchase or the use of alternatives to NCTIC’s products and services, could have a material adverse effect on NCTIC.
A downgrade by ratings agencies, reductions in statutory capital and surplus maintained by NCTIC, the Company’s title insurance underwriter, or a deterioration in other measures of financial strength could adversely affect the Company.
The financial strength of NCTIC may be measured by ratings provided by ratings agencies and levels of statutory capital and surplus maintained by NCTIC, in determining the amount of a policy they will accept and the amount of reinsurance required. Demotech currently rates the NCTIC’s operations. NCTIC’s financial strength ratings are “S” by Demotech, Inc. This rating provides the agency’s perspective on the financial strength, operating performance and cash generating ability of the operation. The agency will continually review these ratings and the ratings are subject to change. Statutory capital and surplus, or the amount by which statutory assets exceed statutory liabilities, is also a measure of financial strength. Accordingly, if the rating or statutory capital and surplus of NCTIC are reduced from the current level, or if there is a deterioration in other measures of financial strength, the NCTIC’s results of operations, competitive position and liquidity could be adversely affected.
The issuance of a title insurance policies and related activities by title agents, some of which operate with substantial independence from the Company, could adversely affect NCTIC.
The Company’s title insurance subsidiaries issue a significant portion of their policies through title agents, some that may operate largely independent of the Company. There is no guarantee that these title agents will fulfill their contractual obligations to the Company’s insurance subsidiaries, which contracts include limitations that are designed to limit NCTIC’s risk with respect to their activities. In addition, regulators are increasingly seeking to hold NCTIC responsible for the actions of these title agents and, under certain circumstances, NCTIC may be held liable directly to third parties for actions (including defalcations) or omissions of these agents. Case law in certain states also suggests that NCTIC is liable for the actions or omissions of its agents in those states, regardless of contractual limitations. As a result, NCTIC’s use of title agents could result in increased claims on the NCTIC’s policies issued through agents and an increase in other costs and expenses.
Errors and fraud involving the transfer of funds may adversely affect the Company’s insurance subsidiaries.
The Company’s insurance subsidiaries rely on their systems, employees and domestic banks to transfer funds on behalf the Company’s insurance subsidiaries as well as title agents that are not affiliates of the Company. These transfers are susceptible to user input error, fraud, system interruptions, incorrect processing and similar errors that from time to time result in lost funds or delayed transactions. The Company’s insurance subsidiaries’ email and computer systems and systems used by its agents, customers and other parties involved in a transaction may be subject to, and may continue to be the target of, fraudulent attacks, including attempts to cause the Company’s insurance subsidiaries or its agents to improperly transfer funds. Funds transferred to a fraudulent recipient are often not recoverable. In certain instances, the Company’s insurance subsidiaries may be liable for those unrecovered funds. The controls and procedures used by the Company’s insurance subsidiaries to prevent transfer errors and fraud may prove inadequate, resulting in financial losses, reputational harm, loss of customers or other adverse consequences which could be material.
Regulatory oversight and changes in government regulation could prohibit or limit the Company or its insurance subsidiaries’ operations, make it more costly or burdensome to conduct such operations or result in decreased demand for their products and services.
The title insurance business is regulated by various federal, state, local governmental agencies and operates within statutory guidelines. The industry in which the title insurance business operates and the markets into which it sells its products are also regulated and subject to statutory guidelines. In general, the title business may be subject to increasing regulatory oversight and increasingly complex statutory guidelines. This may be due, among other factors, to the passing of, and significant changes in, laws and regulations pertaining to privacy and data protection.
Regulatory oversight could require the Company to raise capital, and/or make it more difficult to deploy capital. For example, regulatory capital requirements for the Company have historically applied only at the subsidiary level, specifically the insurance underwriter subsidiaries. However, the National Association of Insurance Commissioners have issued a proposal for group capital calculations. The proposal, if finalized and adopted in their current forms, may apply to the Company at the group level and would be in addition to existing subsidiary-level capital requirements. It is possible that the requirements, particularly in an economic downturn, could have the effect of requiring the Company to raise capital and/or making it more difficult to otherwise deploy capital.
In addition, changes in the applicable regulatory environment, statutory guidelines or interpretations of existing regulations or statutes, enhanced governmental oversight or efforts by governmental agencies to cause customers to refrain from using the Company’s insurance subsidiaries’ products or services could prohibit or limit its future operations or make it more costly or burdensome to conduct such operations or result in decreased demand for their products and services or a change in its competitive position. The impact of these changes would be more significant if they involve the Florida jurisdiction, as all of the Company’s title premiums are currently generated in the state of Florida. These changes may compel the Company to reduce its prices, may restrict its ability to implement price increases or acquire assets or businesses, may limit the manner in which the Company conducts its business or otherwise may have a negative impact on its ability to generate revenues, earnings and cash flows.
Regulation of title insurance rates could adversely affect the Company
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Title insurance rates are subject to extensive regulation, which varies from state to state. In many states the approval of the applicable state insurance regulator is required prior to implementing a rate change. These regulations could hinder the Company’s insurance subsidiaries’ ability to promptly adapt to changing market dynamics through price adjustments, which could adversely affect its results of operations, particularly in a rapidly declining market.
Changes in certain laws and regulations, and in the regulatory environment in which the Company operates, could adversely affect the Company
Federal and state officials are discussing various potential changes to laws and regulations that could impact the Company’s businesses, including the reform of government-sponsored enterprises such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) and additional data privacy regulations, among others. Changes in these areas, and more generally in the regulatory environment in which the Company’s insurance subsidiaries and its customers operate, could adversely impact the volume of mortgage originations in the United States and the Company’s insurance subsidiaries competitive position and results of operations. In addition, in connection with the coronavirus pandemic, the Company’s insurance subsidiaries and generally its agents have been deemed in most areas an essential business and have been permitted to operate. A change in this determination, particularly in jurisdictions where the Company generates a large portion of its revenues, could adversely impact the Company’s insurance subsidiaries’ business.
Actual claims experience could materially vary from the expected claims experience reflected in the NCTIC’s reserve for incurred but not reported claims
NCTIC maintains a reserve for incurred but not reported (“IBNR”) claims pertaining to its title, insurance products. The majority of this reserve pertains to title insurance policies, which are long-duration contracts with the majority of the claims reported within the first few years following the issuance of the policy. Generally, 70% to 80% of claim amounts become known in the first six years of the policy life, and the majority of IBNR reserves relate to the six most recent policy years. Changes in expected ultimate losses and corresponding loss rates for recent policy years are considered likely and could result in a material adjustment to the IBNR reserves. Loss rates for recent policy years, positive or negative, may vary significantly given the long duration nature of a title insurance policy. In uncertain economic times, such as those currently being experienced as a result of the coronavirus pandemic, larger changes may be more likely. Material changes in expected ultimate losses and corresponding loss rates for older policy years is also possible, particularly for policy years with loss ratios exceeding historical norms. The estimates made in determining the appropriate level of IBNR reserves could ultimately prove to be materially different from actual claims experience.
Changes in laws or regulations impacting real estate, particularly when applied retroactively, may cause a material change in expected ultimate losses and corresponding loss rates for recent and/or older policy years.
Risks related to our common stock
Our common stock is listed on the OTCQB and there may be limited ability to trade our common stock.
Trading of our common stock is currently conducted in the over-the-counter market on the OTCQB, which is generally a less active, and therefore a less liquid, trading market than other types of markets such as stock exchanges. As a result, an investor may find it more difficult to dispose of, or obtain accurate quotations for the price of, our common stock than if our stock was traded on other markets.
Risks related to our management
Our executive officers and some of our current and former directors may have potential or actual conflicts of interest because of their positions with HCPM and HC Realty
Steven A. Hale II, our Chairman and Chief Executive Officer, is sole manager of HPCM which serves as the investment adviser for the Hale Funds and two current holders of HC Realty Series B Stock. The Hale Funds own approximately 33.8% of our outstanding common stock. We also own HC Realty Series B Stock and HC Realty Common Stock. Mr. Hale also serves as Chairman and Chief Executive Officer and a director of HC Realty. Bradley G Garner, our Principal Financial and Accounting Officer, also serves as a director of HC Realty and is chief compliance officer for HPCM. Matthew A. Hultquist, one of our former directors, also serves as a director of HC Realty and is a part time employee of HC Realty serving as Senior Vice President - Acquisitions.
Mr. Hale and Mr. Garner owe fiduciary duties to us, as well as to HC Realty as a result of their positions with HC Realty and to the Hale Funds and two current holders of HC Realty Series B Stock as a result of their positions with HPCM, the investment adviser to these parties. Mr. Hultquist used to owe fiduciary duties to us and currently owes such duties to HC Realty. As a result, these executive officers and current and former directors may have potential or actual conflicts of interest when faced with decisions that could have different implications for us and HC Realty. In addition, Mr. Hale and Mr. Garner may have potential or actual conflicts of interest when faced with decisions that could have different implications for us and the Hale Funds or the two holders of HC Realty Series B Stock advised by HPCM. For example, these potential conflicts could arise over matters such as funding and capital matters.
Our executive officers, directors and 10% stockholders have significant voting power and may vote their shares in a manner that is not in the best interest of other stockholders.
Our current executive officers, directors and 10% stockholders control approximately 75.8% of the voting power represented by our outstanding common stock. If these stockholders act together, they may be able to exert significant control over our management and affairs requiring stockholder approval, such as the election of directors or the dissolution of the company. This concentration of ownership may have the effect of delaying or preventing a change in control and might adversely affect the market price of our common stock. This concentration of ownership may not be in the best interests of all our stockholders.
Our management, who will be employed on a part-time basis for the foreseeable future, currently has outside business interests that will require their time and attention and may interfere with their ability to devote all of their time to our business, which may adversely affect our business and operations.
Our only employees consist of our two executive officers, who will be employed for the foreseeable future on a part-time basis and who have outside business interests that could require substantial time and attention. Our executive officers are associated with Hale Partnership Capital Management LLC and devote significant time to its affairs. Our executive officers are also associated with HC Realty. On March 19, 2019, we acquired an equity interest in HC Realty and made a loan to HC Realty’s operating partnership. We cannot accurately predict the amount of time and attention that will be required of our officers to perform their ongoing duties related to outside business interests. The inability of our officers to devote sufficient time to managing our business could have a material adverse effect on our business and operations.